International Financial Management 1

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Chapter 1 Multinational Financial

Management: An Overview

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Pre-class Discussion• What is the appropriate definition of an MNC?• Why does an MNC expand internationally?• What are the risks of an MNC which expands

internationally?• Why must purely domestic firms be concerned

about the international environment?

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Objectives

This chapter provides a background on the goals of an MNC and the potential risks and returns from engaging in international business. The specific objectives are :

• to identify the main goal of the MNC and conflicts with that goal;

• to describe the key theories that justify international business;

• 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.

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Conflicts with the MNC Goal

• For corporations with shareholders who differ from their managers, a conflict of goal can exist -the agency problem.

• Agency costs are normally larger for MNCs than for purely domestic firms.

* The scattering of distant subsidiaries. * The different culture background of subsidiary managers. * The sheer size of the MNC. * Subsidiary value versus overall MNC value.

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• The magnitude of agency costs can vary with the management style of the MNC.

( Exhibit 1.1 & Exhibit 1.2)

* A centralized management style reduces agency costs. * A decentralized style gives more control to those managers who are closer to the subsidiary’s operations and environment, yet may result in higher agency costs.

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Exhibit 1.1 Centralized

Multinational Financial Management

Cash Management at Subsidiary A

Financial Managers of Parent

Inventory and Accounts

Receivables Management at Subsidiary A

Financing at Subsidiary A

Capital Expenditures at

Subsidiary A

Capital Expenditures at

Subsidiary B

Cash Management at Subsidiary B


Receivables Management at

Subsidiary B

Financing at Subsidiary B

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Exhibit 1.2 Decentralized

Multinational Financial Management

Cash Management at Subsidiary A

Financial Managers of Subsidiary A

Financial Managers of Subsidiary B

Cash Management at Subsidiary B


Receivable Management at Subsidiary A


Receivable Management at Subsidiary B

Financing at Subsidiary A

Capital Expenditures at Subsidiary A

Capital Expenditures at Subsidiary B

Financing at Subsidiary B

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* 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.

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• 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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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. (The International Product Life Cycle: Exhibit 1.3)

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Exhibit 1.3 International Product Life Cycle

Firm creates product to accommodate local demand ①

Firm differentiates product from competitors and /or expands product line in foreign country ④a

Firm’s foreign business declines as its competitive advantages are eliminated ④b

Firm exports product to accommodate foreign demand

②

Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs

③

or

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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 facilitate international trade by

enabling firms to advertise and manage

orders through their websites.

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* Licensing allows a firm to provide its

technology in exchange for fees or some

other benefit.

* Franchising obligates a firm to provide a

specialized sales or service strategy,

support assistance, and possibly an

initial investment in exchange for periodic

fees.

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* Joint ventures

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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* Firms can also penetrate foreign markets by establishing new foreign subsidiaries . Summary: * In general, any methods of conducting business that requires a direct investment in foreign operation 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

• Opportunities in Europe

• Opportunities in America

• Opportunities in Asia

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International Risk Exposure

• International business usually increases an MNC’s exposure to:

* exchange rate movements Exchange rate fluctuation affect cash flows and foreign demand. * foreign economies Economic conditions affect demand. * political risk Political actions affect cash flows.

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Overview of an MNC’s Cash Flows

• MNCs focused on international trade. (Exhibit1.5)

• MNCs focused on international trade and international arrangements. (Exhibit1.6)

• MNCs focused on international trade, international arrangements, and direct f

oreign investment. (Exhibit 1.7)

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Cash Flow Diagrams for MNCs Exhibit 1.5 MNCs Focused on International Trade

U.S.-based

MNC

U.S. Customers

U.S. Businesses

Foreign importers

Foreign Exporters

Payments Received for Products

Payments made for Supplies

Payments Received for Exports

Payments made for imports

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Cash Flow Diagrams for MNCs

Exhibit 1.6 MNCs Focused on International Trade and International Arrangements

U.S.–based

MNC

U.S. Customers

U.S. Businesses

Foreign importers

Foreign Exporters

Foreign Firms

Foreign Firms





Fees Received for Services Provided

Expenditures Resulting from Serviced Provided

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Cash Flow Diagrams for MNCs

Exhibit 1.7 MNCs Focused on International Trade, International Arrangements, and Direct Foreign Investment

U.S.-based MNC

U.S. Customers

U.S. Businesses

Foreign Importers

Foreign Exporters

Foreign Firms

Foreign Firms

Foreign Subsidiaries

Foreign Subsidiaries





Fees Received for Services Provided

Expenditures Resulting from Services Provided

Funds Remitted Back to U.S. Parent

Funds Invested in Foreign Subsidiaries

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Managing for Value

• Like domestic projects, foreign projects involve an investment decision and a financing decision.• When managers make multinational financial 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

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

n

ttt

k1=

$,

1

CF E = Value

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Valuation Model for an MNC

• Valuing International Cash Flows

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = the weighted average cost of capital of the U.S. parent company

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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 MNCImpact of New International Opportunities

on an MNC’s Value

Exchange Rate Risk

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

Economic, Political & Exchange Rate Risk

Exposure toForeign Economies and

political conditions

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How Chapters Relate to Valuation

Background on International Financial Environment

(Chapters 1-2)

Exchange Rate Behavior

Short-Term Investment and

Financing Decisions

(Chapters 7-9)

Long-Term Investment and

Financing Decisions

(Chapters 10-15)

Exchange Rate Risk Management

(Chapters 3-6)

Risk and Return of

MNC

Value and Stock Price

of MNC

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Questions and Applications1.Fort Worth Inc. specializes in manufacturing some basic parts for sports utility vehicles that are produced and sold in the U.S. Its main advantage in the U.S. is that its production is efficient, and less costly than that of some other unionized manufacturers. It has a substantial market share in the U.S. Its manufacturing process is labor-intensive. It pays relatively low wages compared to U.S. competitors, but has guaranteed the local workers that their job positions will not be eliminated for the next 30 years. It hired a consultant to determine whether it should set up a subsidiary in Mexico, where the parts would be produced. The consultant suggested that Forth Worth should expand for the following reasons. Offer your opinion on whether the consultant’s reasons are logical:

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Questions and Applications a. Theory of Competitive Advantage: There are not many SUVs sold in Mexico, so Fort Worth Inc. would not have to face much competition there. b. Imperfect Markets Theory: Fort Worth Inc. can not easily transfer workers to Mexico, but it can establish a subsidiary there in order to penetrate a new market. c. Product Cycle Theory: Fort Worth Inc. has been successful in the U.S. It has limited growth opportunities because it already controls much of the U.S. market for the parts it produces. Thus, the natural next step is to conduct the same business in a foreign country.

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Questions and Applicationsd. Exchange Rate Risk. The exchange rate of the peso has

weakened recently, so this would allow Fort Worth Inc. to

build a plant at a very low cost (by exchanging dollars for

the cheap pesos to build the plant).

e. Political Risk. The political conditions in Mexico have

stabilized in the last few months, so Fort Worth should

attempt to penetrate the Mexican market now.

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Questions and Applications 2. Nantucket Travel Agency specializes in tours for American tourists. Until recently, all of its business was in the U.S. It just established a subsidiary in Athens, Greece, which provides tour services in the Greek islands for American tourists. It rented a shop near the port of Athens. It also hired residents of Athens, who could speak English and provide tours of the Greek islands. The subsidiary’s main costs are rent and salaries for its employees and the lease of a few large boats in Athens that it uses for tours. American tourists pay for the entire tour in dollars at Nantucket’s main U.S.

office before they depart for Greece.

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Questions and Applications

a. Explain why Nantucket may be able to effectively capitalize on international opportunities such as the Greek island tours.b. Nantucket is privately-owned by owners who reside in the U.S. and work in the main office. Explain possible agency problems associated with the

creation of a subsidiary in Athens, Greece. How can Nantucket attempt to reduce these agency costs?c. Greece’s cost of labor and rent are relatively low. Explain why this information is relevant to Nantucket’s decision to establish a tour business in Greece.

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Questions and Applicationsd. Explain how the cash flow situation of the Greek tour business exposes Nantucket to exchange rate risk. Is Nantucket favorably or unfavorably affected when the euro (Greece’s currency) appreciates against the dollar? Explain.e. Nantucket plans to finance its Greek tour business. Its subsidiary could obtain loans in euros from a bank in Greece to cover its rent, and its main office could pay off the loans over time. Alternatively, its main office could borrow dollars and would periodically convert dollars to euros to pay the expenses in Greece. Does either type of loan reduce the exposure of Nantucket to exchange rate risk? Explain. f. Explain how the Greek island tour business could expose Nantucket to country risk.

Documents

International Financial Management 1