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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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Conflicts with the MNC Goal
• 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
Inventory and Accounts
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
Inventory and Accounts
Receivable Management at Subsidiary A
Inventory and Accounts
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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Conflicts with the MNC Goal
* 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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Conflicts with the MNC Goal
• 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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International Business Methods
* 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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International Business Methods
* 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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International Business Methods
* 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
Payments Received for Products
Payments made for Supplies
Payments Received for Exports
Payments made for imports
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
Payments Received for Products
Payments made for Supplies
Payments Received for Exports
Payments made for imports
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.