CHAP 1: MULTINATIONAL FINANCIAL MANAGEMENT AN

OVERVIEW

Objectives
● MNC Management goal & organizational structure
● Theories why MNC engage in international business
● Common methods used to conduct international business
● Model for valuing MNC

1-1 Managing the MNC

★ MNC: Firms that engage in international business
★ Main goal: To maximize shareholder wealth (especially when shareholders are the
ones providing funds to company)
★ Additional goals: To satisfy government, creditors & employees
★ Goal of maximizing the entire MNC’s value (rather than the value of any particular
subsidiary)

1-1a How Business Disciplines Are Used to Manage the MNC

Management - Develop strategies to motivate & guide
employees
- To organize resources for efficient production

Marketing - To increase consumer awareness about the

product (promote)
- To recognize changes in consumer preferences
(know the current trend)

Accounting and information - Record financial information (revenue &

systems expenses)
- To report financial information to investors
- To evaluate outcomes from different strategies

Finance - Make investment and financing decisions for

MNC

Common finance decisions:

★ Whether to pursue new business in a particular country
★ Whether to expand business in a particular country
★ How to finance expansion in a particular country
★ Whether to discontinue operations in a particular country
1-1b Agency Problems

★ Agency problem: Conflict of goals between a firm’s managers and shareholders

★ Agency cost: costs of ensuring that managers maximize shareholder wealth
★ Agency cost usually are larger for MNC because:
- More difficult to monitor managers in foreign countries
- Different cultures may not follow main goals (Ex: Instead of prioritizing
shareholders’ interests, some believe that priority should be to their
employees)
- Larger MNC can create significant agency problems because it is complicated
to monitor all managers
★ Lack of monitoring can lead to substantial losses.
★ Controls:
Parent control - Clearly communicate the goals for MNC as a whole
- Oversee subsidiary decisions to ensure they fulfill
MNC’s goals
- Implement compensation plans that reward managers
that satisfy goals:
i) Offer to buy stock at a fixed price - managers directly
benefit from higher stock price when they make
decision that enhance MNC value
ii) Manager annual bonus linked with subsidiary’s
earnings

Corporate - Induce managers to make decisions that satisfy the

control MNC’s shareholder
- If managers make poor decisions that reduce the
MNC’s value, another firm might acquire at lower price;
the new owner would then probably remove the weak
managers.
- Institutional investors (for example, mutual and pension
funds) with large holdings of an MNC’s stock have
some influence over management and may complain
to the board of directors if managers are making poor
decisions.

SOX improve - Ensures a more transparent process of reporting on

CG of MNCs the productivity and financial condition
- Methods:
i) Centralized database
ii) Ensure all data are reported consistently
iii) Implement a system that detect unusual
discrepancies
iv) Speeding the process for all to access data
- Reduce the likelihood of manipulation
- Improve accuracy of existing and potential investors
1-1c Management Structure of an MNC

Centralized Decentralized

PROS Can reduce agency cost because May be more effective if subsidiary
parent control foreign subsidiaries managers recognize the goal of
(reduce subsidiary managers power) maximizing the value of the overall
MNC and are compensated in
accordance with that goal

CONS Parent’s managers may make poor May result to higher agency cost if
decisions for the subsidiary if they are subsidiary manager fail to make
less informed about subsidiary’s decision that maximize MNC value
specific setting and financial
characteristics

★ Some MNC might use both:

- Subsidiary make key decision
- Parent still monitor

1-2 Why MNCs Pursue international Business

3 theories:
● Comparative advantage
● Imperfect market
● Product cycle

1-2a Theory of Comparative Advantage

Definition Specialization by countries can increase worldwide production.

Elaboration ● Because these benefits are difficult to be transferred, countries

prefer to specialise in the production of goods that can be
produced relatively efficiently.
● A country that specializes in some products may not produce
other products, so trade between countries is essential

Examples ● Japan & United States: Technology advantage

● China & Malaysia: Low labour cost
● Virgin Islands specialize in tourism only
- Rely on international trade for its products
- Can focus on its tourism activities rather than produce the
products needed
1-2b Imperfect Markets Theory
Definition ● Firms may strive to use foreign factors of production when they
are less costly than local factors
● Because the cost to transfer labour and other resources needed
in production might be expensive

Examples ● Gap and Nike

- capitalize on a foreign country’s resources by
manufacturing their products in countries with low labor
costs

1-2c Product Cycle Theory

Definition Stage 1:
A firm initially established locally.

Stage 2:
Export to foreign markets due to foreign demand for its product.

Stage 3:
If the product becomes very popular in foreign countries, it may produce
its product in foreign market. (reduce transportation cost)

Stage 4:
After some point, its foreign business may decline unless it can
differentiate its product from competitors.

Examples Facebook
- Initially established its business in the United States, but quickly
recognized that its service was desired by consumers in other
countries.

1-3 Methods to Conduct International Business

1-3a International trade

International trade ● Export & Import
● Minimal risk - no capital at risk

1-3b Licensing
Definition ● Firm provides its technology (copyrights, patents, trademarks, or
 trade names) in exchange for fees or other considerations.

Benefit ● Can generate revenue from foreign countries without

- Establishing any production plants in foreign countries
- Or transporting goods

1-3c Franchising
Definition In exchange for ongoing payments, the firm provides
● a specialised sales or service strategy
● support
● initial investment
allowing local residents to own and manage the specific units.

Example Mcd, Pizza Hut, Subway

DFI Yes (limited degree)

1-3d Joint ventures

Definition Venture that is jointly owned and operated by two or more firms.

Benefit Allow 2 firms to apply their respective comparative advantages.

DFI Yes (limited degree)

1-3e Acquisitions of Existing Operations

Definition Acquire other firms in foreign countries to penetrate foreign markets.

Benefits ● Give firms full control over their foreign business

● Enable the MNC to quickly obtain a large portion of foreign
market share.

DFI Yes (large)

Cons ● May lead to large losses (large investment needed)

● If foreign operations perform poorly - difficult to sell at reasonable
price
1-3f Establishment of New Foreign Subsidiaries
Definition Establish new operations in foreign countries to produce and sell their
products.

Benefits ● Operations can be tailored exactly to the firm’s needs

● ​Smaller investment may be required than if purchasing existing
operations.

Cons No reward from the investment until the subsidiary is built and a
customer base established.

DFI Yes (large)

1-3g Summary of methods

Cash flow diagrams for MNCs:
1-4 Valuation Model for an MNC
1-4a Domestic Valuation Model

Dollar Cash Flows ● Funds received - Funds need for pmt of

expenses/taxes/reinvest
● Good decision can;
- Increase expected future CF
- Increase firms’ value

Cost of Capital ● Required rate of return (k) represents cost of capital (cost of
capital & debt on all of the firm’s projects)
● If firm’s credit rating is suddenly lowered
- COC might increase
- Required rate of return also will increases
● Increase in firm’s k will
- Reduce value of firm (because expected CF must be
discounted at a higher interest)

1-4b Multinational Valuation Model

★ Same with domestic value BUT must consider expected CF from various countries
(different currencies)
i) Dollar Cash Flows of an MNC That Uses Two Currencies

Carolina Co. expects cash flows from its :

● local business $100,000

● Foreign business MXP 1,000,000

Assuming that the peso’s value is expected to be $0.09 when converted into dollars, the
expected dollar cash flows are:

The cash flows from U.S. business were already denominated in U.S. dollars, so they did not
need to be converted.

ii) Dollar Cash Flows of an MNC That Uses Multiple Currencies

- Same like 2 currencies but add more currencies

iii) Valuation of an MNC’s Cash flows over Multiple Periods

Assume that Austin Co. plans to maintain its business operations in the same way in the
United States and Europe for the next three years.

As a basic valuation model, the firm could use last year’s cash flows to estimate each
future year’s cash flows; then its expected cash flows would be $66 million for each of the
next three years.

Its valuation could be estimated by discounting these cash flows at its cost of capital.

1-4c Uncertainty Surrounding an MNC’s Cash Flows

Exposures:
International Economic Cash flow depends on:
Conditions - Sales (depend on foreign consumers demand)
- Consumer demand (depend on country’s national
income)

High national income

High employment rate
High money to spend
High demand for MNC product

Effect on home economy

- If country’s economy strengthen

- Consumer buy more from other countries
- The other countries will have stronger sales & CF

International Political Risk - Govt may increase taxes

- Impose barriers on MNC’s subsidiary
- Local consumers boycott MNC (if tension occurs
between the 2 countries)

Exchange Rate Risk - If foreign currencies to be received suddenly

weaken against the dollar
- MNC will receive a lower amount of dollar cash
flows than expected.

If currency appreciate against dollar:

Inflows = Favourable
Outflows (to make payment) = Unfavourable

Example: Expected to receive 16 million euros

Exchange rate = $1.30 x 16M euros= $20,800,000
Exchange rate = $1.20 x 16M euros = $19,200,200
➔ Expected CF reduces
1-4d How Uncertainty Affect the MNC’s Cost of Capital
Higher uncertainty on MNC’s future cash flows

➔ investors would require a higher expected rate of return, which increases the MNC’s
cost of obtaining capital and lowers its valuation.
CHAP 2: INTERNATIONAL FLOW OF FUNDS

Objectives
● Key components of the balance of payments
● Growth in international trade activity over time
● How international trade flows are influenced by economic and other
factors.
● How international capital flows are influenced by country
characteristics.
● Agencies that facilitate the international flow of funds.

2-1 Balance of Payments

★ Definition:
Summary of transactions between domestic and foreign residents for a specific
country over a specified period of time.
★ Include transaction by:
- Businesses
- Individuals
- Government
★ Components of BOP:
- Current account
- Capital account
- Financial account

2-1a Current Account

★ Flow of funds between a specific country and all other countries due to:
- Purchases of goods and services
- Income generated by assets
★ Main components:

1 Payments of G&S ● From import & export

● Balance of trade = Total exports - total imports
● Deficit balance of trade = Export < Import

2 Primary Income ● Income earned by MNCs on:

- Dividend from - DFI (investment in fixed assets in foreign
stock countries that can be used to conduct business
- Interest from operations)
bond - income earned by investors on their portfolio
 - Earnings from investments
subsidiaries
● Net primary income = Primary income receipts -
primary income payments

3 Secondary Income ● Aid, grants, and gifts from one country to

another.
● Net secondary income =
Secondary income receipts - secondary income
payments

★ Cash inflow: Debit

Cash outflow: Credit

2-1b Financial Account

★ Flow of funds between countries due to:
- direct foreign investment
- portfolio investment
- other capital investment

1 DFI ● Payments for DFI in US (funds are flowing into

the US)
= positive
● Payments by US-based MNC’s DFI in another
country (funds being sent from US to another
country)
= negative

2 Portfolio ● Investment in financial assets (stock/bond)

investment

3 Other capital ● Transactions involving short-term financial

investment assets (such as money market securities)

2-1c Capital Account

★ Flow of funds between countries due to:
- financial assets transferred across country borders by people who move to a
different country
- sales of patents and trademarks.
2-2 Growth in International Trade
Benefits:
- Create more jobs
- Prompts a transfer in production to countries with more efficient manufacturing
capabilities.
- Ensures more global competition among producers -> forces those firms to keep their
prices low.
- More product choices at lower prices.

Disadvantages:
- Worker in certain industries lose their jobs as production has shifted to countries with
lower labor costs

2-2a Events That Increased Trade Volume

1. Fall of the Berlin Wall
2. Single European Act
3. NAFTA
4. GATT
5. The European Union
6. Inception of the Euro
7. Other Trade Agreements

2-2b Impact of Outsourcing on Trade

Definition The process of subcontracting to a third party in another country to provide
supplies/service that were previously produced internally

Benefits - Increases international trade activity

Ex: The U.S outsource computer systems to India
- Allows MNCs to operate at a lower cost
- Created many jobs in countries where wages are low

Criticism - Reduce the number of jobs in home country

- Counterback: Might need to shut down labor-extensive operations
if they don't outsource because the labor cost is too high in home
country (U.S)

Managerial Decisions about Outsourcing

● Many manager may argue that they produce their products in the home country to
create job for the locals
● But if the same product can be produced at a significant lower cost
● Shareholders may pressure managers to:
- Establish foreign subs or
- Outsource
2-2c Trade Volume among Countries
★ U.S annual international trade volume = 10 - 20% of the GDP
★ ​The U.S is less reliant on trade than many other developed countries.

2-2d Trend in U.S Balance of Trade

★ The U.S has experienced large balance-of-trade deficits
- strong U.S. demand for imported products that are produced at a lower cost
than similar products can be produced in the United States.

2-3 Factors Affecting International Trade Flows

2-3a Cost of Labor - Ex: China have low labour cost
- Have an advantage when competing globally especially
in labor-intensive industries

2-3b Inflation When inflation increases:

- Price of G&S increases
- People from other country don’t want to buy
- Export decreases

- People from home country buy cheaper product from

foreign country
- Import increases

* Increase in country’s inflation may cause its current account to

decrease

2-3c National - High income

Income - Citizen & businesses choose to buy foreign products
= import > export

* Current account decreases

2-3d Credit - More restrictive

conditions - Banks less willing to provide financing to MNC
- MNC reduce corporate spending
- Weakens the economy
- Reduce demand for imported supplies

2-3e Government i) Restrictions on Imports

Policies ● Tariff
- Tax imposed by a government on imported
goods.
- Causing consumers to purchase fewer foreign
goods and more domestically produced goods.
- Domestic industries are protected.
● Quota
- Maximum limit imposed by the government on
goods allowed to be imported into a country.
ii) Subsidies for Exporters
- Offer subsidies to its domestic firms to enable them to
produce products at a lower cost than their global
competitors
- Attracting more demand for their exports.
- Dumping: Exporting of products that were produced with
the help of government subsidies

iii) Restrictions on Piracy

- Government that does not act to minimize piracy
- May indirectly reduce imports
- May even discourage MNCs from exporting to that
market.

iv) Environmental Restrictions

- Some governments are loosening or entirely eliminating
environmental restrictions to ensure that local firms can
compete globally.

v) Labor Laws
- Firms based in countries with more restrictive laws will
incur higher expenses for labor
- Hard to compete with other countries

vi) Business Laws

- Some countries have more restrictive laws on bribery
than others
- Hard to compete globally
- Example: When a government from a country expect
MNC to give gifts to secure the business in that country
but the MNC’s country is actually strict about this

vii) Tax Breaks

- The government may give tax breaks to firms that
operate in specific industries
- Ex: Invest in R&D

viii) Country Trade Requirements

- Require MNCs to complete various forms
- Obtain licences before exporting goods to its country
- Might be purposely inefficient to discourage exporters
- Bureaucracy: government delays trade requests (a form
of retaliation to hinder trade and protect local jobs)

ix) Government Ownership or Subsidies

- Some governments maintain ownership in firms that are
major exporters
 x) Country Security Laws

xi) Policies to Punish Country Governments

- Some want their governments to impose new trade
restrictions that would punish other countries that do not
enforce environmental laws or child labor laws, or that
commit human rights violations.

2-3f Exchange - Exchange rate: Value of a currency in terms of other

Rates currencies
- Demand for both imported product & local product can
shift as a result of a change in the exchange rate

How Exchange Rates May Correct a Balance-of-Trade

Deficit (I > E)
- Floating exchange rate
- The locals import when foreign product currency is weak
against its currency (means cheaper)
- Example: RM weak against USD
- When people use a lot of its currency (USD) to buy
foreign goods in other currency (RM)
- RM will become expensive because more people will
demand for that currency to buy foreign goods
- And vice versa, this places downward pressure on USD
- USD becomes cheaper, so there will be more foreign
demand for its product

Why Exchange Rates May Not Correct a Balance-of-Trade

Deficit
- Foreign competitors might lower their price too to remain
competitive
- Many international trade transactions are prearranged
and cannot be adjusted immediately to fluctuating
exchange rates (committed to contract)
- J curve
- When its international trade involves importers and
exporters under the same ownership - transaction will
usually continue

International Friction Caused by Exchange Rate

Manipulation
Example 1 (Demand for imports):
Malibu Co (U.S) produces tennis rackets
Price: $140

Competitor Accel Co (in Netherlands)

Price: 100 Euros

Situation 1: Exchange rate= $1.60 per Euro

From US consumers POV:

Malibu Co.’s racket Accel Co.’s racket

$140 $1.60 x 100 Euro

= $160
➔ Malibu is cheaper
➔ U.S. demand for Accel is low
➔ Malibu’s cash flow is strong

Situation 2: Exchange rate= $1.20 per Euro (Euro has weakened)

From US consumers POV:

Malibu Co.’s racket Accel Co.’s racket

$140 $1.20 x 100 Euro

= $120
➔ Accel is cheaper
➔ U.S. demand for Accel is high
➔ Malibu’s cash flow is weak

Example 2 (Demand for exports):

Malibu (U.S.) also export tennis racket to a retailer in the eurozone

So it competes with Accel in that market.

Situation 1: Exchange rate= $1.60 per Euro

From Eurozone consumers POV:

Malibu Co.’s racket Accel Co.’s racket

$140/$1.60 100 Euros

= 87.50 Euros
➔ Malibu is cheaper
➔ Eurozone demand for Malibu racket is high
➔ Malibu’s cash flow is strong
 Situation 2: Exchange rate= $1.20 per Euro (Euro has weakened)

From US consumers POV:

Malibu Co.’s racket Accel Co.’s racket

$140/$1.20 100 Euros

= 117 Euros
➔ Accel is cheaper
➔ Eurozone demand for Malibu racket is low
➔ Malibu’s cash flow is weak

● When currencies are strong against US (dollar is weak)

- US import will be low
- US export will be high
- Favorable balance-of-trade (export > import)

● When currencies are weak against US (dollar is strong)

- US import will be high
- US export will be low
- Less favorable balance-of-trade (import > export)

2-4 International Capital Flows

★ DFI - to get more customers & utilize low-cost labour
★ The U.S attracts more DFI than any other country

2-4a Factors Affecting DFI

Changes in restrictions - Lower restriction, more DFI
- Less developed countries (more opportunities)

Privatization - Foreign firms can acquire operations sold by

national governments.
- MV of a firm may increase due to improvement in
managerial efficiency

Potential economic growth - Greater potential, more attractive

Tax rates - Low tax rate, more attractive

Exchange rates - Expectation that local currency will strengthen

against their own, attractive!
- Can invest funds to establish operation in the
country when the currency is weak.
2-4b Factors Affecting International Portfolio Investment
Funds invested by individual/institutional investors prefers:

Tax Rates on Interest or Tax on interest or dividend income from investments

Dividends are low

Interest Rates High interest rate (as long as local currencies are
not expected to weaken)

Exchange Rates If home currency is expected to strengthen

- Foreign investor willing to invest in the
country’s securities

If home currency is expected to weaken

- Foreign investors may prefer to purchase
securities in other countries.

2-4c Impact of International Capital Flows

2-5 Agencies that Facilitate International Flows

1. International Monetary Fund
2. World Bank
3. World Trade Organization
4. International Finance Corporation
5. International Development Association
6. Bank for International Settlements
7. OECD
8. Regional Development Agencies