1.3 Goals of International Finance

Goals of international finance are the reasons why businesses undertake international finance. Firms engage in international finance in an effort to achieve similar goals as the local businesses. These goals/objectives include the following:

1. Shareholder Wealth Maximization – according to this goal, managers are expected to make decisions that maximize the net-worth of the shareholder or increase the value of the share price of the firm. Net-worth is the residual value after all liabilities are deducted from the firm’s assets.
2. Profit Maximization – The goal of every business is to make profits. The ability of a business to remain afloat is determined by its ability to make profits ensure growth and gain competitive advantage. This objective is related to the shareholder wealth maximization goal because profits increase shareholder net-worth.
3. Maximize Market Share – market share is the ratio of the firm’s sales to that of the industry. the ratio measures competitive advantage of the firm to its peers. A firm thus may pursue this goal as it expands internationally.
   
4. Satisfying Government – Organizations must abide by the statutes set by countries where they operate. These laws include taxation, effluent management among others.
5. Social Responsibility – Firms should impact the society where they operate by improving its welfare. As such the firm may use its resources in management of environment, contribution to social welfare, etc.
6. Satisfying Creditors and Suppliers – Making decisions that take into consideration the welfare of the parties the firm owes resources such as banks and credit suppliers.
7. Welfare of Customers – The goal may require ensuring products are of right quality and reasonably priced.
8. Welfare of employees – Employees are a key resource to a firm. The firm may thus seek to maximize their well-being by offering reasonable remuneration, and working conditions.

The Agency Problems

An agency relationship exists when a principal delegates some powers/authority to another party (agent). A firm has various stakeholders who have varying interests on the firm. These interests create agency conflicts as discussed below:

1. Shareholders – Management Agency Problem:

As organizations grow in size, their management is usually separated from the owners. This separation however, creates a conflict of interests between the owners and the management.

Sources of Shareholder – Management Conflict

• Conflicting Incentives/motivations – management interest is on their remuneration while that of the owners is profits. Where there is no goal congruence between the two parties, management may undermine the achievement of higher profits if they are not benefiting from it, for instance if their salaries are fixed.
• Motivations to take risk – Management may be willing to take on less risk than the shareholder prefer in order to reduce they risk of bankruptcy and loss of their managerial capital. On the other hand, the shareholders may be fearing for loss of their capital. Managers may also undertake highly risky investments to increase their earnings.
• Creative accounting – When compensation is tied to performance, the management may result to inflation of returns through inconsistent treatment of performance items such as early recognition of revenue viz-a-viz cost.
• Investment Horizons – managers may prefer short-term returns to long-term ones, while shareholders focus on long-term returns.
• Control of the company – Managers may avoid any actions or decisions that would lead to change in ownership of the firm even if this would be more beneficial to the shareholders, in order to protect their interests.

Mitigating Shareholder-Management Conflict

• Performance based remuneration – Management can be compensated depending on the level of achievement of the goals set by the owners such as profitability. This is considered a goal alignment approach.
• Share Option Plan – allowing management a share in the ownership structure of the firm lead to alignment of their goals to those of the original owners. This option seeks to cure the problems of investment horizon, and risk aversion.
• Threat of firing – shareholders are the owners of the business, thus, they have the power to hire and fire the managers if they so wish. The fear of firing leads to alignment of the managers’ goals to those of the shareholders.
• Threat of takeover – shareholder have the ability to dispose their stake to any party they wish. This decision may not be welcomed by management, thus any threat may influence their actions.
• Direct intervention by shareholder – shareholders can influence management decision through AGM voting on decisions at AGMs, representation in board, or taking legal actions.
• Incurring agency costs – agency costs include any cost incurred in an attempt to monitor or enforce certain actions of the agent (management). These costs include:
  •  Monitoring costs – they include costs incurred in controlling the actions of the management such as internal control system costs, reporting costs, audit costs, etc.
  • Contracting Costs – they are costs for drawing and implementing contract set to guide and stipulate acceptable actions by each party – shareholders and management.
  • Opportunity loss – in an attempt to ensure shareholders’ interests are met, the controls may lead to sub-optimal decisions, such as slow decision making due to bureaucracy.
  • Restructuring Costs – In an attempt to align managements’ goals with those of the shareholders, the shareholder may incur costs of changing processes including roles and systems.

b. Creditors – Management (Shareholders) Agency Problems:

By using debt to fund their operations, managers (shareholders) agree to incur agency costs and limit their freedom in making decisions such as type of projects to undertake and additional financing. Conflicts arise when the firm makes decisions that seek to reduce its ability to repay both the principal amount owing and interest (if applicable). These sources of conflict are as follows.

Sources of Conflict:

1. Higher Risk Investments – the firm may, after acquiring a debt, engage in more riskier investments lowering the ability to repay the debt plus interest.
2. Disposal of collateral – the firm that uses some of its assets to secure a debt is required to hold that asset in its portfolio until the debt is settled. Any action contrary to this, would lead to conflict of interest.
3. Increased consumption – actions that reduce the net-worth of the firm such as high-value dividends, disposal of key assets, undermines the firm’s ability to meet its obligations.
4. Increased leverage – By borrowing more debts, the firm’s assets may be unable to cover all liabilities in case of liquidation.
5. Redirection of borrowed funds –  A firm may borrow money to undertake a certain investment but use the funds to meet other needs such as payment of another debt. this affects the ability of the firm to eventually repay all debts as scheduled.

Remedies to the Agency Problems:

1. Protective covenants – covenants may be either positive covenants or negative covenants. Positive covenants require performance of certain actions such as maintenance of a certain level of working capital or provision of periodic financial reports. Negative covenants, also called restrictive covenants, limit or prohibit certain actions such as entering into another debt agreement, disposal of key assets, dividend amount limitation, or restriction on merger/acquisation.
2. Custody of Collateral – the lender may require transfer of the asset used as security from the firm borrowing.
3. Board Representation – By having a seat in the board of directors, the lender ensures his interests are covered in decisions of management.
4. Decline the request to lend – Where the lender considers the borrower a high risk, he may refuse to give out the debt or require a punitive interest rate/terms.
5. Embedded options – embedded options are used to attract lender who may consider the firm risky borrower or as way of getting favorable interest rates. embedded options include convertibility of the debt into stocks or callability of debt at specified periods.

c. Host – Subsidiaries Agency Problems:

While subsidiaries may have their local goals such as to increase production by investing additional capital, the parent company may be seeking to fund a different project.

To harmonize these goals, all decisions must always be viewed from the parent’s perspective.