Chapter I

MULTINATIONAL FINANCIAL MANAGEMENT

Chapter Objectives


Main goal of the MNC and conflicts with that goal; Key theories that justify international business; and the common methods used to conduct international business. Valuation model for an MNC

Goal of the MNC



MNC is a firm that has incorporated on one country and has production and sales operations in other countries. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets.

Global 500
Revenues
1 2 3 4 5 6 7 8 9 10 Exxon Mobil Wal-Mart Stores Royal Dutch Shell BP General Motors Chevron DaimlerChrysler Toyota Motor Ford Motor ConocoPhillips 339,938.0 315,654.0 306,731.0 267,600.0 192,604.0 189,481.0 186,106.3 185,805.0 177,210.0 166,683.0

Profits
36,130.0 11,231.0 25,311.0 22,341.0 -10,567.0 14,099.0 3,536.3 12,119.6 2,024.0 13,529.0

Source: Fortune 2006 Global 500 List

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 Against the MNC Goal of Maximizing the Value of the Firm


For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem. Agency costs are normally larger or smaller 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.

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 subsidiarys operations and environment.

Impact of Management Control



Electronic networks make it easier for the parent to monitor the actions and performance of foreign subsidiaries. For example, corporate intranet or internet email facilitates communication. Financial reports and other documents can be sent electronically too.

Impact of Corporate Control



Various forms of corporate control can reduce agency costs.

1.

2. 3.

Stock compensation for board members and executives. The threat of a hostile takeover. Monitoring and intervention by large shareholders.

Constraints Interfering with the MNCs Goal



As MNC managers attempt to maximize their firms value, they may be confronted with various constraints.
Environmental constraints. Regulatory constraints. Ethical constraints.

Theories of International Business

Why are firms motivated to expand their business internationally?
1. Theory of Comparative Advantage
Specialization by countries can increase production efficiency.

2. Imperfect Markets Theory

The markets for the various resources used in production are imperfect.

Theories of International Business

Why are firms motivated to expand their business internationally?
3. Product Cycle Theory
As a firm matures, it may recognize additional opportunities outside its home country.

The International Product Life Cycle

Firm creates product to accommodate local demand. Firm exports product to accommodate foreign demand. Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

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

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

International Business Methods

There are several methods by which firms can conduct international business.
1.

International trade is a relatively conservative approach involving exporting and/or importing.

The internet facilitates international trade by enabling firms to advertise and manage orders through their websites.

International Business Methods

2.

3.

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.

International Business Methods

4.

5.

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.

International Business Methods

6.

7.

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.

Degree of International Business by MNCs

Fo Fo
70% 60% 50% 40% 30% 20% 10% 0% Campbell's Dow Soup Chemical IBM Motorola Nike

gn S

% o To

gn Assets as a % o Total Assets

62% 46%

66% 58% 50% 40% 33% 47%

26% 12%

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.

International Opportunities
Cost-benefit Evaluation for Purely Domestic Firms versus MNCs
Investment Opportunities Purely Domestic Firm

Marginal Return on Projects Marginal Cost of Capital

MNC MNC Purely Domestic Firm

Financing Opportunities

Appropriate ize for Purely Domestic Firm

Appropriate ize for MNC

Asset Level of Firm

Exposure to International Risk

International business usually increases an MNCs exposure to:

exchange rate movements

Exchange rate fluctuations affect cash flows and foreign demand.

foreign economies
Economic conditions affect demand.

political risk
Political actions affect cash flows.

Overview of an MNCs Cash Flows

Profile A: MNCs focused on International Trade
Payments for products

U. . Customers U. . Businesses Foreign Importers Foreign Exporters

U. .based MNC

Payments for supplies Payments for exports Payments for imports

Overview of an MNCs Cash Flows

Profile B: MNCs focused on International Trade and International Arrangements. More complex than A.
Payments for products Payments for supplies

U. . Customers U. . Businesses Foreign Importers Foreign Exporters Foreign Firms

U. .based MNC

Payments for exports Payments for imports Fees for services Costs of services

Overview of an MNCs Cash Flows

Profile C: MNCs focused on International Trade, International Arrangements, and Direct Foreign Investment
Payments for products Payments for supplies

U. . Customers U. . Businesses Foreign Importers Foreign Exporters Foreign Firms Foreign ubsidiaries

U. .based MNC

Payments for exports Payments for imports Fees for services Costs of services Funds remitted Funds invested

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 firms value, and hence shareholder wealth.

Valuation Model for an MNC. This idea occurs throughout the course.


Domestic Model
n

=
t =1

E  $, t CF

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

Valuation Model for an MNC



Valuing International Cash Flows

E E CFj , t v E  n !1 j = t 1  k t =1

j , t

E (CFj,t ) = expected cash flows denominated in currency j to be received by the U. . 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. . parent company.

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. The international environment limits the decisions: elasticities of demand, conditions of supply, home and foreign government interventions.

Valuation Model for an MNC

Impact of New International Opportunities on an MNCs Value
Exposure to Foreign Economies
m n j 1

Exchange Rate Risk

? CF E ER A E
j, t j, t

Value =
t =1

k
t

Political Risk

Valuation Model for an MNC



A US firm has expected cash flows (CF) of $100,000 from local business and 1,000,000 Mexican peso from business at the end of year 1. What is the expected dollar CF if the value of peso is $.09 and interest rate is 10% per annum?

Homework
Chapter 1 Private study questions: 1, 2, 3, 7,11,13