Part I

The International Financial Environment

Multinational Corporation (MNC)

Foreign Exchange Markets

Dividend
Remittance
Exporting & Financing Investing
& Importing & Financing

Product Markets Subsidiaries International

Financial
Markets
 1
Chapter

Multinational Financial Management:

An Overview
 Chapter Objectives

• To identify the main goal of the

multinational corporation (MNC) and
conflicts with that goal;
• To describe the key theories that justify
international business; and
• To explain the common methods used to
conduct international business.

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 Goal of the MNC
• The commonly accepted goal of an MNC is to maximize
shareholder wealth.
• We will focus on MNCs that are based in the United States
and that wholly own their foreign subsidiaries.
• MNCs are defined as firms that engage in some form of
international business.
• They tend to focus on niches that have made them
successful in the home country and tend to penetrate
specialty markets where they need not compete with larger
firms that could capitalize on economies of scale.

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 Conflicts Against the MNC Goal
• For corporations with shareholders who
differ from their managers, a conflict of
goals can exist – This conflict is referred to
as the agency problem.
• Agency costs are normally larger for MNCs
than for purely domestic firms.
¤ The sheer size of the MNC.
¤ The scattering of distant subsidiaries.
¤ The culture of foreign managers.
¤ Subsidiary value versus overall MNC value.
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 Impact of Management Control

• The magnitude of agency costs can vary

with the management style of the MNC.
• A centralized management style reduces
agency costs. However, a decentralized
style gives more control to those
managers who are closer to the
subsidiary’s operations and environment.

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 Impact of Management Control

• Some MNCs attempt to strike a balance -

they allow subsidiary managers to make
the key decisions for their respective
operations, but the decisions are
monitored by the parent’s management.
• In the U.S. most of the MNCs wholly own
foreign subsidiaries and this enables
finance managers to have a single goal of
maximizing the value of the entire MNC.

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 Impact of Management Control

• Electronic networks make it easier for the

parent to monitor the actions and
performance of foreign subsidiaries.
• For example, corporate intranet or internet
email facilitates communication. Financial
reports and other documents can be sent
electronically too.

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 Impact of Corporate Control

• Various forms of corporate control can

reduce agency costs.
¤ Stock compensation for board members
and executives.
¤ The threat of a hostile takeover.
¤ Monitoring and intervention by large
shareholders.

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 Constraints
Interfering with the MNC’s Goal
• As MNC managers attempt to maximize
their firm’s value, they may be confronted
with various constraints.
¤ Environmental constraints.
¤ Regulatory constraints.
¤ Ethical constraints.

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Theories of International Business

Why are firms motivated to expand

their business internationally?
 Theory of Comparative Advantage
¤ Specialization by countries can increase
production efficiency.
 Imperfect Markets Theory
¤ The markets for the various resources
used in production are “imperfect.”

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Theories of International Business

Why are firms motivated to expand

their business internationally?
 Product Cycle Theory
¤ As a firm matures, it may recognize
additional opportunities outside its home
country.

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 Theory of comparative advantage

• Specialization in some products may result in no

production of other products, so that trade
between two countries is essential. Comparative
advantages enable firms to penetrate foreign
markets.For eg. Virgin islands specialize in
tourism and rely completely on international
trade for other products. Though it is possible to
produce some goods, the islands are better off
using revenues earned through tourism to import
products.

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 Imperfect markets theory

• If markets were perfect, factors of production

(excluding land) would be mobile and freely
transferable. Unrestricted mobility would cause
equality in costs and returns and remove the
comparative cost advantage. However, the real
world suffers from imperfect market conditions
where factors (labour, funds and other resources)
are somewhat immobile.

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 Product cycle theory

• As time passes and firms become established in

home market, the only way for the firms to retain
its advantage over competition in foreign
countries is to produce the product in foreign
markets, thereby reducing transportation costs.
Over time, competition may increase in foreign
country too and the firm may have to resort to
other strategies like differentiation so that
competitors cannot offer exactly the same
product.

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 International
Business Methods
There are several methods by which firms
can conduct international business.
• International trade is a relatively
conservative approach involving
exporting and/or importing.
¤ The internet facilitates international trade
by enabling firms to advertise and manage
orders through their websites.

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 International
Business Methods
• Licensing allows a firm to provide its
technology in exchange for fees or some
other benefits.
• Franchising obligates a firm to provide a
specialized sales or service strategy,
support assistance, and possibly an initial
investment in the franchise in exchange
for periodic fees.

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 International
Business Methods
• Firms may also penetrate foreign markets
by engaging in a joint venture (joint
ownership and operation) with firms that
reside in those markets.
• Acquisitions of existing operations in
foreign countries allow firms to quickly
gain control over foreign operations as
well as a share of the foreign market.

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 International
Business Methods
• Firms can also penetrate foreign markets by
establishing new foreign subsidiaries.
• In general, any method of conducting
business that requires a direct investment in
foreign operations is referred to as a direct
foreign investment (DFI).
• The optimal international business method
may depend on the characteristics of the MNC.

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 International Opportunities

• Investment opportunities - The marginal

return on projects for an MNC is above that
of a purely domestic firm because of the
expanded opportunity set of possible
projects from which to select.
• Financing opportunities - An MNC is also
able to obtain capital funding at a lower cost
due to its larger opportunity set of funding
sources around the world.

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 International Opportunities

• Opportunities in Europe
¤ The Single European Act of 1987.
¤ The removal of the Berlin Wall in 1989.
¤ The inception of the euro in 1999.
• Opportunities in Latin America
¤ The North American Free Trade Agreement
(NAFTA) of 1993.
¤ The General Agreement on Tariffs and Trade
(GATT) accord.

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 International Opportunities

• Opportunities in Asia
¤ The reduction of investment restrictions by
many Asian countries during the 1990s.
¤ China’s potential for growth.
¤ The Asian economic crisis in 1997-1998.

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 Exposure to International Risk
International business usually increases an
MNC’s exposure to:
 exchange rate movements
¤ Exchange rate fluctuations affect cash flows and
foreign demand.
 foreign economies
¤ Economic conditions affect demand.
 political risk
¤ Political actions affect cash flows.

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 Managing for Value

• Like domestic projects, foreign projects

involve an investment decision and a
financing decision.
• When managers make multinational
finance decisions that maximize the
overall present value of future cash flows,
they maximize the firm’s value, and hence
shareholder wealth.

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 Valuation Model for an MNC

• Domestic Model
n
E  CF$, t 
Value = 
t =1 1  k  t

E (CF$,t ) = expected cash flows

to be received at the end of period t
n = the number of periods into
the future in which cash flows are
received
k = the required rate of return
by investors A1 - 25
 Valuation Model for an MNC
• Valuing International Cash Flows
m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows
denominated in currency j to be received by the
U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
the end of period t
k = the weighted average cost of capital
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 Valuation Model for an MNC

• An MNC’s financial decisions include how

much business to conduct in each country
and how much financing to obtain in each
currency.
• Its financial decisions determine its
exposure to the international environment.

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Valuation Model for an MNC
Impact of New International Opportunities
on an MNC’s Value

Exposure to
Foreign Economies Exchange Rate Risk

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1   1  k  t

 

Political Risk
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Framework for financial decisions

• In decisions involving deployment of the

firm’s financial resources, the treasurer
must strive to maximise the expected
return, subject to the constraint that the
associated risk does not exceed the level
acceptable to management.

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Nature and measurement of exposure
and risk

• Macroeconomic environmental risks:

Changes in values of a firm’s assets,
liabilities and operating income in
response to financial variables like
exchange rates, interest rates and inflation
rates.

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 Core business risks

• Specific to a firm
• Interruption in raw material supplies, labour
troubles, failure of new product or technology.
• Uncertainties create strategic exposure and risk
for a firm.
• Exposure is a measure of the sensitivity of the
value a a financial item (asset, liability or cash
flow) to changes in the relevant risk factor, while
risk is a measure of variability of the value of the
item.

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 Exchange rate and interest rate
volatility

• Increased awareness of exchange rate risk

is due to tremendous increase in the
volume of cross border financial
transactions.

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 Chapter Review

• Goal of the MNC

¤ Conflicts Against the MNC Goal
¤ Impact of Management Control
¤ Impact of Corporate Control
¤ Constraints Interfering with the MNC’s Goal
• Theories of International Business
¤ Theory of Comparative Advantage
¤ Imperfect Markets Theory
¤ Product Cycle Theory

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 Chapter Review

• International Business Methods

¤ International Trade
¤ Licensing
¤ Franchising
¤ Joint Ventures
¤ Acquisitions of Existing Operations
¤ Establishing New Foreign Subsidiaries

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 Chapter Review

• International Opportunities
¤ Investment Opportunities
¤ Financing Opportunities
¤ Opportunities in Europe
¤ Opportunities in Latin America
¤ Opportunities in Asia

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 Chapter Review

• Exposure to International Risk

¤ Exposure to Exchange Rate Movements
¤ Exposure to Foreign Economies
¤ Exposure to Political Risk
• Managing for Value

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 Chapter Review

• Valuation Model for an MNC

¤ Domestic Model
¤ Valuing International Cash Flows
¤ Impact of Financial Management and
International Conditions on Value

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