International
Financial Management
12th Edition
by
Jeff Madura
Florida Atlantic University
Chapter
1
Multinational Financial Management:
An Overview
Chapter Objectives
• To identify the management goal and
organizational structure of the MNC,
• To describe the key theories about why MNCs
engage in international business
• To explain the common methods used to
conduct international business.
• To provide a model for valuing the MNC
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Financial management
• Financial management is about planning and controlling the
financial affairs of an organisation, to ensure that the
organisation achieves its objectives, particularly its
financial objectives. This involves decisions about:
• How much finance the business needs for its operations,
both its day-to-day operations and for longer-term
investment projects.
• Where the finance should be obtained from: long-term
finance is raised as equity capital (share capital and profits)
or as debt capital, and short-term finance is obtained mainly
from trade suppliers and bank overdrafts.
• What should be the balance between long-term and short-
term finance, and what should be the balance between
equity capital and debt capital.
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Financial management
• Investing short term cash surpluses.
• Ensuring that the providers of finance are
suitably rewarded: the organisation must make
sure that it can meet the interest payments on its
borrowing, and companies must ensure that
shareholders receive an appropriate dividend out
of profits.
• Where appropriate, protecting the organisation
against financial risks.
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Identifying the main financial objective
• A financial objective can be expressed in a number
of different ways, and there are advantages and
weaknesses or limitations with each. Three
commonly-used financial objectives are to
maximise:
• Shareholder wealth
• Profitability
• Growth in earnings per share.
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What is International Financial
management?
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Goal of the MNC
• The commonly accepted goal of an MNC is
to maximize shareholder wealth.
• Some publicly traded MNCs based outside
the United States may have additional goals,
such as satisfying their respective
governments, creditors, or employees.
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Finance Decisions
• Finance is used to make investment and financing
decisions for the MNC. Common finance decisions
include:
■ Whether to discontinue operations in a particular
country,
■ Whether to pursue new business in a particular
country,
■ Whether to expand business in a particular
country, and
■ How to finance expansion in a particular country.
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Agency Problems
• Managers of an MNC may make decisions that conflict with
the firm’s goal of maximizing shareholder wealth.
• For example, a decision to establish a subsidiary in one
location versus another may be based on the location’s
appeal to a particular manager rather than on its potential
benefits to shareholders. A decision to expand a subsidiary
may be motivated by a manager’s desire to receive more
compensation rather than to enhance the value of the MNC.
This conflict of goals between a firm’s managers and
shareholders is often referred to as the agency problem.
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Conflicts Against the MNC Goal
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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How this problem can be solved?
• The parent should clearly communicate the goals for each
subsidiary to ensure that all of them focus on
maximizing the value of the MNC and not of their respective
subsidiaries.
• The parent can oversee subsidiary decisions to check
whether each subsidiary’s managers are satisfying the
MNC’s goals.
• The parent also can implement compensation plans that
reward those managers who satisfy the MNC’s goals.
• The threat of a hostile takeover.
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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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Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Cash Financial Cash
Management Managers Management
at A of Parent at B
Inventory and Inventory and
Accounts Accounts
Receivable Receivable
Management at A Management at B
Financing at A Financing at B
Capital Expenditures Capital Expenditures
at A at B
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Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Cash Financial Financial Cash
Management Managers Managers Management
at A of A of B at B
Inventory and Inventory and
Accounts Accounts
Receivable Receivable
Management at A Management at B
Financing at A Financing at B
Capital Expenditures Capital Expenditures
at A at B
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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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Theory of Comparative Advantage
• Some countries, such as Japan and the United States, have a
technology advantage, whereas others, such as China and
Malaysia, have an advantage in the cost of basic labor.
• Because these advantages cannot easily be transported,
countries tend to use their advantages to specialize in the
production of goods that can be produced with relative
efficiency.
• This explains why countries such as Japan and the United
States are large producers of electronic products while
countries such as Jamaica and Mexico are large producers of
agricultural and handmade goods.
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Imperfect Markets Theory
• The real world suffers from imperfect market conditions
where factors of production are somewhat immobile.
• There are costs and often restrictions related to the transfer
of labor and other resources used for production. There also
may be restrictions on transferring funds and other resources
among countries.
• Because markets for the various resources used in
production are “imperfect,” MNCs such as the Gap and Nike
often capitalize on a foreign country’s particular resources.
Imperfect markets provide an incentive for firms to seek out
foreign opportunities.
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Theories of International Business
Product Cycle Theory:
According to this theory, firms become established in the home
market as a result of some perceived advantage over existing
competitors. Because information about markets and
competition is more readily available at home, a firm is likely to
establish itself first in its home country. Foreign demand for the
firm’s product will initially be accommodated by exporting.
As time passes, the firm may feel the only way to retain its
advantage over competition in foreign countries is to produce
the product in foreign markets, thereby reducing its
transportation costs.
As a firm matures, it may recognize additional opportunities
outside its home country.
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The International Product Life Cycle
Firm creates Firm exports
product to product to Firm
accommodate accommodate establishes
local demand. foreign demand. foreign
subsidiary
to establish
presence in
a. Firm or foreign
differentiates b. Firm’s country
product from foreign and
competitors business possibly to
and/or expands declines as its reduce
product line in competitive costs.
foreign country. advantages are
eliminated.
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International
Business Methods
There are several methods by which firms
can conduct international business.
■ International trade
■ Licensing
■ Franchising
■ Joint ventures
■ Acquisitions of existing operations and
■ Establishment of new foreign subsidiaries.
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International
Business Methods
• International trade is a relatively conservative
approach involving exporting and/or importing.
• This approach entails minimal risk because the firm does not
place any of its capital at risk.
If the firm experiences a decline in its exporting or importing,
it can normally reduce or discontinue that part of its business
at a low cost.
• 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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Cash Flow Diagrams for MNCs
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Degree of International Business by MNCs
Foreign Sales as a % of Total Sales
Foreign Assets as a % of Total Assets
70%
66%
62% 58%
60% 50%
46% 47%
50% 40%
40% 33%
30%
26%
20% 12%
10%
0%
Campbell's Dow IBM Motorola Nike
Soup Chemical
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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
Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Purely
Investment
Domestic
Opportunities MNC
Marginal Firm
Return on
Projects MNC
Purely
Marginal Domestic
Cost of Firm
Capital
Financing Appropriate
Opportunities Size for Purely Appropriate
Domestic Firm Size for MNC
X Y Asset Level
of Firm
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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
• 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
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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 of the U.S.
parent company
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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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Potential Effects of International Economic Conditions
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Exposure to International Political Risk
Political risk in any country can affect the level of an MNC’s
sales.
• A foreign government may increase taxes
• A foreign government may impose barriers on the MNC’s
subsidiary.
• Consumers in a foreign country may boycott the MNC if there
is friction between the government of their country and the
MNC’s home country.
Political actions like these can reduce the cash flows of an
MNC. The term “country risk” is commonly used to reflect an
MNC’s exposure to a variety of country conditions, including
political actions such as friction within the government,
government policies (such as tax rules), and financial conditions
within that country.
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Exposure to Exchange Rate Risk
• If the foreign currencies to be received by a U.S.-
based MNC suddenly weaken/strengthen against
the dollar, then the MNC will receive a lower
amount/higher amount of dollar cash flows than
expected. Therefore, the MNC’s cash flows will be
reduced.
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Practice:
• Carolina Co. has expected cash flows of $100,000
from local business and 1 million Mexican pesos
from business in Mexico at the end of period t.
Assuming that the peso’s value is expected to be
$.09 when converted into dollars, the expected
dollar cash flows are:
• EC = $ CF from US operations + $ CF from
operations in Mexico
= $ 100,000 + (1,000,000 pesos (.09))
= $ 100,000 + $ 90,000
= $190,000.
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Practice:
• Austin Co. is a U.S.-based MNC that sells video games to
U.S. consumers; it also has European subsidiaries that
produce and sell the games in Europe. The firm’s European
earnings are denominated in euros (the currency of most
European countries), and these earnings are typically
remitted to the U.S. parent. Last year, Austin received $40
million in cash flows from its U.S. operations and 20 million
euros from its European operations. The euro was valued at
$1.30 when remitted to the U.S parent, so Austin’s cash flows
last year are calculated as follows:
• Actual Cash Flow = $ 66,000,000.
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Chapter Review
• Goal of the MNC
¤ Conflicts Against the MNC Goal
¤ Impact of Management 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
• Overview of an MNC’s Cash Flows
• Exposure to International Risk
¤ Exposure to Exchange Rate Movements
¤ Exposure to Foreign Economies
¤ Exposure to Political Risk
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Chapter Review
• Valuation Model for an MNC
¤ Domestic Model
¤ Valuing International Cash Flows
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Check your concept
• Explain how the existence of imperfect markets has
led to the establishment of subsidiaries in foreign
markets.
• Do you think the acquisition of a foreign firm
or licensing will result in greater growth for an
MNC? Which alternative is likely to have more
risk?
• What factors cause some firms to become more
internationalized than others?
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Practice
• AB, the producer of soft drinks, has engaged in a joint venture
with Kirin Brewery, the largest brewery in Japan. The joint
venture enabled AB to have its beer distributed through Kirin’s
distribution channels in Japan. In addition, it could utilize
Kirin’s facilities to produce beer that would be sold locally. In
return, AB provided information about the Bangladeshi market
to Kirin.
a. Explain how the joint venture enabled AB to achieve its
objective of maximizing shareholder wealth.
b. Explain how the joint venture limited the risk of the
international business.
c. Many international joint ventures are intended to circumvent
barriers that normally prevent foreign competition. What
barrier in Japan did AB circumvent as a result of the joint
venture?
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Assignment
• Advanced Question-20, 23, 29, 31
• Case-Blades Inc.
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