Chapter 1

Multinational Financial Management: An Overview

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?

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.

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 subsidiarys 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 Cash Management at Subsidiary B Inventory and Accounts Receivables Management at Subsidiary B

Inventory and Accounts Receivables Management at Subsidiary A

Financing at Subsidiary A

Capital Expenditures at Subsidiary A

Capital Expenditures 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 balancethey allow subsidiary managers to make the key decisions for their respective operations, but the decisions are monitored by the parents management.

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

Firm exports product to accommodate foreign demand

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

or
Firms foreign business declines as its competitive advantages are eliminated b

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

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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 16

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 MNCs 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 MNCs 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 foreign investment.
(Exhibit 1.7)
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Cash Flow Diagrams for MNCs

Exhibit 1.5 MNCs Focused on International Trade
Payments Received for Products

U.S. Customers U.S. Businesses Foreign importers Foreign Exporters

Payments made for Supplies

U.S.-based MNC
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
Payments Received for Products Payments made for Supplies

U.S. Customers U.S. Businesses Foreign importers Foreign Exporters Foreign Firms Foreign Firms
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U.S.based MNC

Payments Received for Exports Payments made for imports

Fees Received for Services Provided
Expenditures Resulting from Serviced Provided

Cash Flow Diagrams for MNCs

Exhibit 1.7 MNCs Focused on International Trade, International Arrangements, and Direct Foreign Investment
Payments Received for Products Payments made for Supplies Payments Received for Exports

U.S. Customers U.S. Businesses Foreign Importers Foreign Exporters Foreign Firms Foreign Firms Foreign Subsidiaries
23 Foreign Subsidiaries

U.S.-based MNC

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

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 firms value, and hence shareholder wealth.
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Valuation Model for an MNC

Domestic Model

Value =
t =1

E ( CF$, t )

(1 + k )

E (CF$,t ) n

= =

expected cash flows to be received at the end of period t the number of periods into the future in which cash flows are received the required rate of return by investors
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Valuation Model for an MNC

Valuing International Cash Flows
m E ( CFj , t ) E (ER j , t ) n j =1 Value = t (1 + k ) t =1

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

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Valuation Model for an MNC

An MNCs 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

Impact of New International Opportunities on an MNCs Value
Exposure to Foreign Economies and political conditions

Exchange Rate Risk

m E ( CFj , t ) E (ER j , t ) n j =1 Value = t (1 + k ) t =1

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Economic, Political & Exchange Rate Risk

How Chapters Relate to Valuation

Exchange Rate Behavior Background on International Financial Environment (Chapters 1-2) Exchange Rate Risk Management (Chapters 3-6)

Short-Term Investment and Financing Decisions (Chapters 7-9) Long-Term Investment and Financing Decisions (Chapters 10-15)

Risk and Return of MNC

Value and Stock Price of MNC

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Questions and Applications

1.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 consultants 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 Applications

d. 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 subsidiarys 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 Nantuckets 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. Greeces cost of labor and rent are relatively low. Explain why this information is relevant to Nantuckets decision to establish a tour business in Greece.
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Questions and Applications

d. 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 (Greeces 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.

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