Chapter 1

Multinational Financial Management: An Overview

Q1. What is Multinational Corporations (MNC’s)
Multinational corporations (MNCs) are defined as firms that engage in some form of
international business. Their managers conduct international financial management, which
involves international investing and financing decisions that are intended to maximize the
value of the MNC.

Q2. Goal of the MNC

1. The commonly accepted goal of an MNC is to maximize shareholder wealth.
2. We will focus on MNCs that wholly own their foreign subsidiaries.
3. Financial managers throughout the MNC have a single goal of maximizing the value
of the entire MNC.

Q3. Conflict Against the MNC Goal

For corporations with shareholders who differ from their managers, a conflict of goals can
exist - 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.

Q4. Agency Problem

Managers of an MNC may make decisions that conflict with the firm’s goal to maximize
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.
Q5. Management Structure of an MNC
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.
Q6. 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 parent’s management
monitors the decisions.
• Today, electronic networks make it easier for the parent to monitor the actions and
performance of its foreign subsidiaries.
• For example, corporate intranet or internet email facilitates communication.
Financial reports and other documents can be sent electronically too.
Q7. 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.
Q8. Constraints Interfering with the MNC’s Goal
MNC managers are confronted with various constraints:
a. Environmental Constraints: Limitations or restrictions imposed on a multinational
corporation (MNC) due to the need to protect and preserve the natural environment.
b. Regulatory Constraints: Legal and administrative restrictions imposed by
governmental authorities on the operations of an MNC.
c. Ethical Constraints: Countries requiring a worldwide code of ethics may be
disadvantaged, because other firms may use tactics that are allowed in some foreign
countries, e.g., use of bribery
A recent study found that investors assigned a higher value to firms that exhibit high
corporate governance standards and are likely to obey ethical constraints.
Q9. Why MNC’s Firms Pursue International Business
The commonly held theories as to why firms become motivated to expand their business
internationally are: 1. the theory of comparative advantage, 2. the imperfect markets theory,
and 3. the product cycle theory.
Q9. Why are Firms Motivated to Expand Their Business Internationally?
1. Theory of Comparative Advantage: Multinational business has generally increased
over time. Part of this growth is due to the heightened realization that specialization by
countries can increase production efficiency. When a country specializes in some products,
it may not produce other products, so trade between countries is essential. This is the
argument made by the classical theory of comparative advantage. Comparative advantages
allow firms to penetrate foreign markets.
2. 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 may also be
restrictions on transferring funds and other resources among countries. Because markets
for the various resources used in production are “imperfect,”
3. Product Cycle Theory: According to this theory, firms become established in the home
market as a result of some perceived advantage over existing competitors, such as a need
by the market for at least one more supplier of the product. Because information about
markets and competition is more readily available at home, a firm is likely to establish
itself first in its home country.
Q10. How Firms Engage in International Business/ Method of Conduct IB
Firms use several methods to conduct international business. The most common methods
are these:
1. International Trade: International trade is a relatively conservative approach that can
be used by firms to penetrate markets (by exporting) or to obtain supplies at a low cost (by
importing). This approach entails minimal risk because the firm does not place any of its
capital at risk.
2. Licensing: Licensing obligates a firm to provide its technology (copyrights, patents,
trademarks, or trade names) in exchange for fees or some other specified benefits.
Licensing allows firms to use their technology in foreign markets without a major
investment in foreign countries and without the transportation costs that result from
exporting.
3. Franchising: 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. For example, McDonald’s, Pizza Hut, Subway Sandwiches, Blockbuster,
and Dairy Queen have franchises that are owned and managed by local residents in many
foreign countries.
4. Joint Ventures: A joint venture is a venture that is jointly owned and operated by two
or more firms. Many firms penetrate foreign markets by engaging in a joint venture with
firms that reside in those markets. Most joint ventures allow two firms to apply their
respective comparative advantages in a given project.
5. Acquisitions of Existing Operations: Firms frequently acquire other firms in foreign
countries as a means of penetrating foreign markets. Acquisitions allow firms to have full
control over their foreign businesses and to quickly obtain a large portion of foreign market
share.
6. Establishing New Foreign Subsidiaries: Firms can also penetrate foreign markets by
establishing new operations in foreign countries to produce and sell their products. Like a
foreign acquisition, this method requires a large investment. Establishing new subsidiaries
may be preferred to foreign acquisitions because the operations can be tailored exactly to
the firm’s needs.
Q11. International Opportunities
1. Investment opportunities: The marginal returns on MNC projects are above those
of purely domestic firms since MNCs have expanded opportunity sets of possible
projects from which to select.
2. Financing opportunities: MNCs can obtain capital funding at a lower cost due to
their larger opportunity set of funding sources around the world.
Q12. Exposure to International Risk
International business usually increases an MNC’s exposure to:
1. Exchange Rate Movements: Exchange rate fluctuations affect cash flows and
foreign demand. If the foreign currencies to be received by a U.S.-based MNC
suddenly weaken against the dollar, the MNC will receive a lower amount of dollar
cash flows than was expected. This may reduce the cash flows of the MNC.
2. Foreign Economies: Economic conditions affect demand.
3. Political Risk: Political risk in any country can affect the level of an MNC’s sales.
A foreign government may increase taxes or impose barriers on the MNC’s
subsidiary. Political actions affect cash flows.
Q13. Overview of an MNC’s Cash Flows
Profile A: MNCs focused on International Trade
 Profile B: MNCs focused on International Trade and International
Arrangements

Profile C: MNCs focused on International Trade, International Arrangements,

and Direct Foreign Investment

Q14. 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.
Q15. Valuation Model for an MNC
The valuation method described in this section can be used to understand the key factors
that affect an MNC’s value in a general sense.
1. Domestic Model: Before modeling an MNC’s value, consider the valuation of a purely
domestic firm that does not engage in any foreign transactions. The value (V) of a purely
domestic firm in the United States is commonly specified as the present value of its
expected cash flows,

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.
2. Valuing International Cash Flows

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.
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.
Example
▪ Suppose, the US multinational has subsidiaries in UK and Bangladesh. In year t, the
cash flow expected from USA is $10,000, from UK is £5,000 and from Bangladesh is
Tk.1million. The expected pound rate is £1=$2 and Taka rate is $1=Tk.70. Then the
cash flow of year t is: (Multiple Currency)
▪ 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: (Two Currency)