International Financial MGMT U4

UNIT 4 i
Long-term aspects of international financial management
Unit 4
BBF 308/05
International Financial
Management
Long-term Aspects
of International
Financial
Management
ii WAWASAN OPEN UNIVERSITY
BBF 308/05 International Financial Management
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UNIT 4 iii
Contents
Unit 4 Long-term Aspects of
International Financial
Management
Unit overview 1
Unit objectives 1
4.1 Country risk analysis 3
Objectives 3
Introduction 3
Rationale for country risk analysis 4
Political risk and financial risk factors 6
Techniques of country risk assessment 9
How to manage country risks? 11
Suggested answers to activities 14
4.2 Foreign direct investment 15
Objectives 15
Introduction 15
Motives 15
How to invest abroad 18
Benefits of international diversification 18
Suggested answers to activity 22

iv WAWASAN OPEN UNIVERSITY
4.3 Multinational capital budgeting 23
Objectives 23
Introduction 23
The perspective of multinational capital budgeting 24
Inputs used for multinational capital budgeting 24
Factors to consider in multinational capital budgeting 26
The process of multinational capital budgeting 27
Long-term financing 31
Long-term financing decisions 31
Financing with fixed rate and floating rate bonds 35
Equity financing 36
Suggested answers to activity 38
Summary of Unit 4 39
Suggested answers to self-tests 41
References 45
UNIT 4 1
Unit Overview
I n Unit 1, you studied the basics of a multinational corporation (MNC),

including the goals, constraints and business methods at its disposal. The
foreign exchange market was introduced in the unit. The structure, operations,
dynamics and history of the exchange market were covered. Unit 2 examined
various forms of international arbitrage and realignment. Three major theories
on interest rate, inflation and exchange rates were illustrated. Unit 3 discussed
the exchange rate risk and possible methods to hedge such risk. In this unit,
you will apply what you have learnt in Units 1 to 3 to the long-term aspects of
international financial management.
Unit 4 focuses on the issues related to the long-term aspect of financial

management within an MNC. The long-term aspect of financial management
can be broadly divided into two categories: macro and micro perspective. The
macro perspective covers issues such as country risk analysis and foreign direct
investment. Both country risk analysis and foreign direct investment topics
examine the host country’s economic environment in which the MNC does
business or the MNC expects to market exports or establish subsidiaries. In
addition, this unit discusses the micro perspective of long-term aspects of
international financial management at the company level. Multinational capital
budgeting and long-term financing are also discussed in some detail. Obviously,
both the macro and micro level of the long-term aspect of multinational
financial management would affect the operations of an MNC.
Unit Objectives
By the end of Unit 4, you should be able to:
1. Conduct country risk assessment.
2. Discuss the management of country risk.
3. Critically discuss foreign direct investment.
4. Apply the principles of multinational capital budgeting on international

project appraisal.
5. Discuss the various types of long-term financing tools.

2 WAWASAN OPEN UNIVERSITY
UNIT 4 3
4.1 Country Risk Analysis

Objectives
By the end of this section, you should be able to:
1. Define country risk analysis and discuss its rationale.
2. Identify techniques of country risk assessment.
3. Discuss methods to manage country risk.
Introduction
This section introduces country risk that MNCs must consider. Country risk is
considered a major factor for long-term financial management at the macro level.
Country risk analysis is usually conducted when an MNC is assessing whether
to begin or continue business in a particular country. In other words, an MNC
must constantly assess the business environments of the countries in which they
are operating, as well as of those that they are considering for investment. If the
country under consideration is at war with a neighbouring country, or frequent
riots break out in the country, doing business there is out of the question.
Country risk is a long-term analysis, since it usually involves the country’s

political climate, social culture and economic development. All of these aspects
usually continue for a longer time and are not easily changed in the short term.
Nowadays, country risk is synonymous with cross-border risk or international
business risk. Clearly, country risk is unavoidable for MNCs. More often, people
refer political risk as country risk, but of course, country risk is more than
political risk. It is a general term, which refers to risks affecting all companies
operating within a particular country.
In this section, we will begin with defining country risk and identifying the
rationale for country risk analysis. Next, several methods to assess country risk are
discussed. You should be aware that country risk assessment is always a difficult
task. Moreover, country risk may change over time. For example, government
policy towards foreign investment may change due to a change in the political
regime. The change in political regime may be unexpected due to unexpected
election results. Finally, the way an MNC can incorporate country risk analysis in
making financial decisions is explained.
Rationale for country risk analysis

Country risk is the potential adverse impact of a country’s environment on the
MNC’s cash flows. Country risk has two components: political risk and financial
risk. Country risk analysis is important for the following reasons:
1. An MNC can use country risk analysis to monitor the risk of countries
where the MNC is currently doing business. If the country risk increases
to an unacceptable level, the MNC may consider selling off its
subsidiaries there.
2. An MNC can use country risk analysis to screen countries before it

engages in any business there.
3. An MNC can use country risk analysis to assess particular forms of risk
for a proposed investment project. For instance, if the proposed project is
in a country with above average country risk, then the MNC has to
factor the country risk into the capital budgeting process.
Among some of the sources of uncertainty are:
Political aspect
1. War.
2. Civil war.
3. Occupation of foreign power.
4. Political crisis.
5. Revolution.
6. Terrorist attack.
7. Takeover by extremist government.
8. State takeover.
9. Change in currency policy say from flexible to fixed regimes.
10. Capital control (transfer risk).
11. Force reinvestment (locally).
12. Trade restrictions.
13. Protectionism on certain industry for national security.

UNIT 4 5
14. Allowable ownership structure.
15. Government debt default.
Government structure
16. Nepotism.
17. Corruption.
18. Bureaucracy.
19. Weak property right protection.
Economic aspect
20. Financial crisis in host market.
21. Recession in host market.
22. Credit squeeze.
23. Unstable macroeconomic fundamentals.
24. Increase in local production costs, such as wages, utilities charges and
even fuel price.
25. Loose corporate governance in the foreign subsidiaries.
26. Weak banking system.
Social aspects
27. Labour strike.
28. Human resource norms.
29. Local consumer attitudes.
30. Active local Non Government Organisation (NGO), which include local
environmental group, anti-globalisat ion movements and labour union.
31. Poor education system with limited pool of highly skilled labour.
32. Poor healthcare system which often lead to outbreak of diseases or viruses.
Primarily, the MNC conducts country risk analysis to assess the general economic
environment of the host country. Sometimes you may think that if the potential
return of a project is high enough, then any degree of country risk can be
tolerated. This is not true. Sometimes, if the country risk is so high that the host
country may pose a danger to the MNC’s employees, or the MNC’s host country’s
assets are possibly being confiscated without compensation, then no expected
return is high enough to warrant the project.
One example of the importance of country risk is from a US-based MNC,

Consolidated Foods, Inc. The MNC set up a new plant in El Salvador in 1976,
because of low labour cost and because El Salvador was a “happy and sleepy
country”. Two years later, political turmoil erupted. In the process, a group of
rebels held the division president and 120 employees of Consolidated Foods, Inc.
hostage until the MNC agreed to a wage increase. By 1979, the plant was closed
and Consolidated Foods, Inc. lost money.
Political risk and financial risk factors

Several risk characteristics of a country may affect the performance of the
MNC’s subsidiaries in that country. An MNC should consider how each of the
characteristics might affect its cash flows. Political risk analysis examines how the
political environment of a host country may affect the cash flow of an MNC.
Financial risk analysis studies how the financial environment of a host country
may affect the cash flow of an MNC. In the following, some of the important
political and financial risks are discussed in more detail, starting with political
risks.
Attitude of consumers in the host country
This is a mild form of political risk to an exporter. Basically, the tendency is for
the host country’s residents to purchase only homemade goods. Even if the MNC
opens subsidiaries in the host country and makes the goods locally, the host
country bias of the consumers can still prevent the MNC from succeeding.
For instance, in the US, consumers are encouraged to look for “made in the USA”
labels. By contrast, consumers in Hong Kong are more “liberal”. Apparently,
some countries have more loyal consumers than other countries. An MNC has
to research the general loyalty of consumers towards homemade goods. If the
loyalty attitude is not very strong, then the MNC does not have to set up a
foreign operation. It can simply export its products to the country. However, if
the host country’s consumers are very loyal to homemade goods, it would be a
better idea for the MNC to enter a joint venture with a local company to produce
and sell the goods locally in the host country.
UNIT 4 7
Attitude of host government
Various actions of the host government can affect the cash flow of an MNC.
Some mild forms of these actions are: changing tax laws that are unfavourable
to the MNC, stricter environmental standards that increase the operating cost
and restriction of funds transfer. More serious action may be a takeover by a host
government without any compensation.
Blockage of funds transfer
It is common for subsidiaries of an MNC to send funds back to the parent MNC
for loan repayment, supplies, administrative fees or other purposes. Sometimes, a
host government may block such funds transfer. This will force the subsidiaries to
spend the funds in the host country.
For instance, before the economic and political opening up of Russia, it was
impossible to send earnings made by an MNC’s Russian subsidiary overseas.
Hence, the MNC usually directed its subsidiary to buy Russian products (e.g.,
vodka) and ship them overseas to “transfer” the funds. Another example is doing
business in China. It is well known in the Hong Kong business world that any
money earned in mainland China is subject to foreign exchange restrictions.
These restrictions include approval from government officials for remitting
earnings overseas in foreign currency, maximum allowance for such remittance,
etc. Obviously, this is not optimal and incurs substantial transaction costs.
Subsequently, the MNC’s earnings are lower than they should be.
War
Some countries may have constant riots; engage in conflict with neighbouring
countries, or experience civil war and revolution. This is surely not a pleasant
environment for doing business, what more for foreign direct investment to come
in. The situation is of high threat to the security and safety of the employees
hired by the MNCs. These countries usually have unstable economies and hence
make the MNC’s earnings unstable.
Bureaucracy
Government bureaucracy is another political risk an MNC faces. The bureaucracy

usually makes things more complicated for an MNC to conduct business in the
host country. It usually delays business decisions and consumes resources.
Corruption
Corruption is another major political risk factor. It increases the cost of doing
business in the host country. For example, an MNC may lose revenue, because a
government contract is awarded to a local firm that paid off a government official.
Transparency International released the corruption perception index ratings

among countries in 1997. Transparency International is a non-governmental
organisation in-charge of curbing corruption. Its headquarters is in Berlin,
Germany.
An example is drawn from www.transparency.org, as shown in Table 1.1. The highest

rating is 10 and the lowest is 0. A perfect rating of 10 indicates a totally corruption-
free country. Moreover, the ranking in Table 1.1 only relates to the results drawn
from a number of surveys conducted by Transparency International and reflects only
the perceptions of business people that participated in the surveys. From the table,
you can see that Russia had the lowest rating.
Country Index Rating Country Index Rating

Finland 9.6 Chile 7.3
New Zealand 9.6 United States 7.3
Denmark 9.5 Spain 6.8
Singapore 9.4 Uruguay 6.4
Sweden 9.2 Taiwan 5.9
Switzerland 9.1 Hungary 5.2
Netherlands 8.9 Malaysia 5.0
Austria 8.6 Italy 4.9
United Kingdom 8.6 Czech Republic 4.8
Canada 8.5 Greece 4.4
Hong Kong 8.3 Brazil 3.9
Germany 8.0 China 3.3
Belgium 7.4 India 3.3
France 7.4 Mexico 3.3
Ireland 7.4 Russia 2.5
Table 1.1 Corruption Index Ratings for Selected Countries (Maximum rating = 10.
High ratings indicate low corruption.)
Source: Transparency International, 2009
The financial risk factor is primarily the state of the economy of the host country.
An MNC that exports to a foreign country will certainly consider the current
and the potential state of economy of the host country. If the economy is good,
other things being equal, the demand for the MNC’s products continues to be
good. However, if the host country is in a recession, the demand for the MNC’s
exports or the products sold by the MNC’s local subsidiary will be adversely
affected. For instance, in the early 1990s, European countries had a mild recession.
Consequently, EuroDisney sales dropped. An example in Hong Kong is the retail
business after 1997. Since late 1997, Hong Kong has experienced an economic
downturn. Retail business, especially operated by Japanese department stores,
was hit very hard.
UNIT 4 9
In addition, when a country is in a recession, its government may implement

policies that could limit the sales growth of an MNC’s products. For example,
Ford Motors could only sell ten percent of the total automobile sales in Spain
in the preceding year. If Spain has a recession and the sale of automobiles drops,
then Ford can only export fewer cars to Spain.
A micro assessment considers all scenarios that affect an industry or a firm

operating in a particular country. The political and financial risk factors are
evaluated at the industry- or firm-specific level. Basically, an MNC has to evaluate
how the industry or the firm reacts to various political and financial risk factors.
Activity 4.1
Country risk assessment by China Toys
China Toys is a Hong Kong-based toys manufacturer that exports

toys and operates retail subsidiaries stores overseas. Its business
has been quite successful in the US and Europe. Now China Toys
is considering expanding its business in China. It plans to build
and operate seven large retail toy stores in major cities in China.
China Toys’ treasurer needs to provide a country risk assessment of
its possible expansion in China. Although the economy in China
has experienced eight percent growth in the last five years, the
stability of the economy depends heavily on political stability.
1. Identify one political factor that you think most affects the
performance of the China Toys stores in China.
2. Explain why the China Toys stores in China are subject to

financial risk.
Techniques of country risk assessment

It is quite common for an MNC to have a system of assessing country risk. Some
of the popular techniques are discussed.
1. Checklist approach
This approach involves judgement on all political and financial factors in

the country risk analysis. Some of the factors are readily available (e.g., the
GNP growth rate of the host country) but other factors are subjectively
determined. It is also common to assign some numerical scores to each
factor and to compute some weighted average scores to compare country
risk among several countries.
2. Delphi technique
This approach involves a group of assessors collecting independent

opinions on country risk. These assessors may be consultants, CEOs of
MNCs, economists, etc. They form opinions without meeting each other.
Then the MNC collects the assessors’ country risk scores on the target
country for business operations or investment. Sometimes, the process
may be repeated several times among the same group of assessors until the
dispersion of the opinions falls into a pre-determined range.
3. Quantitative analysis
This approach uses quantitative research techniques to examine the

country risk of a host country. Essentially, the approach applies statistical
techniques such as regression analysis or discriminant analysis to historical
data to identify important factors that contribute to a high country risk.
For instance, by examining the historical information with a regression
model, a GNP growth rate for a developing country significantly predicts
whether the host country would experience political turmoil. Then the
regression model can be used to predict the country risk of a host country,
given the GNP growth rate.
4. Inspection visit
This approach involves travelling to the host country and meeting with
the host government officials, local businesses and consumers. From the
meetings, the MNC management then assesses the country risk.
In general, most MNCs would use a combination of techniques to assess country

risk. The following reading discusses the techniques of country risk assessment and
comparison of risk ratings among countries. When you read the following excerpts,
pay particular attention to the section about how to quantify country risk.
Web Reference
For more information on techniques to assess country risk, please

refer to http://www.investopedia.com/articles/economics/12/
evaluate-country-risk.asp
After reading, please do the following activity.

UNIT 4 11
Activity 4.2
Hong Kong Star, Inc., a Hong Kong-based MNC, is considering

to establish a subsidiary in Poland that produces Chinese food
products. All the raw materials are from Poland. The Chinese food
products are sold in Poland and other Eastern European countries.
Hong Kong Star is very interested in the project, since there are
presently no competitors in Chinese food products in Eastern
Europe. A consultant is hired to assess the country risk of Poland.
The consultant, through his business network in Poland, surveys
the opinions of 100 Polish small business owners. His findings are
summarised as follow:
Mean score (from 1 to 10, with 10 the

Factors
best or less risky)
Political stability 6.0
Risk of labour strike 7.5
Risk of high inflation 7.5
GNP growth 7.5
Export stability 8.5
1. Which country risk assessment technique does the consultant

use?
2. From the consultant’s findings, what should be the concern

for Hong Kong Star, according to country risk?
How to manage country risks?

Having analysed the host country’s political and economic environment, an MNC
may take action to control its exposure to the country risk in the host market, or to
decide whether or not to invest or continue to invest there.
Of course, the simplest approach to the management of country risk is to avoid it

in the first place. However, if the MNC decides to go ahead, then it might want
to structure the investment and business planning so as to minimise country risk.
There are a few approaches that can minimise country risk:
The first approach is to take precaution policy before entering a host market. For
example, purchasing political risk insurance to cover its foreign assets, especially
to protect against expropriation. By paying some insurance premium, the MNC
do not need to worry about the threat of local expropriation. For example, the one
provided by the World Bank, Multilateral Investment Guarantee Agency (MIGA)
is designed to cover political risks for direct investment in less developed countries.
The second approach a MNC can do is to reach an agreement with the host
government before any investment can be made. The agreement should spell out
the rights and responsibilities on the parts of both parties, particularly on the
rules under which the MNC can operate locally. This approach, however, is solid
only if the government is a strong government. Otherwise, a change in the ruling
party will not guarantee the protection against political risks.
An MNC may also strategise its business and operations structure to reduce the
possibility of political risks arising from its subsidiaries. This can be done through
various methods listed as follow:
1. Employ local workers.
2. Joint venture with local firms.
3. Introduce local shareholders and stakeholders.
4. Thin equity base in foreign subsidiaries.
5. Sourcing capital from local banks and capital markets.
6. Project financing which is separated from the MNC that manages the
project.
7. Control on the technology, brand name or trademark that cannot be

duplicated legally even after local expropriation.
8. Employ a local legal advisor.
9. Diversifying the parent MNC’s operations in more than one country.
Also, the MNC might want to fulfil its social obligation to the local communities
to create a home-base image in the host country. Besides providing employment
opportunities to local labours, the MNC can also contribute to local charities,
invest in local human development and various sort of community services.
Practically, it would be very costly for an MNC to start everything from scratch.
Therefore, most MNCs would begin their country risk assessment by referring to
outside research. One common source is Euromoney’s annual country risk rating.
UNIT 4 13
Web Reference
You can also obtain country risk reports from the following
websites:
1. Business Monitor International
http://www.businessmonitor.com/
2. Countryrisk.com
https://www.countryrisk.com/
3. Economist Intelligence Unit
http://store.eiu.com/product/60000206.html?ref=Products
4. Political Risk Services Group
http://www.prsgroup.com/
5. The Benche
https://www.thebenche.com/countryreports/
Summary
This completes the first section of Unit 4. In this lesson, you

have been introduced the definition of country risk. There are
several dimensions of country risk, mainly political, government
structure, economic and social. Special attention is devoted to
political and financial aspect of country risk because they pose
direct impact on the business and cash flow of MNCs. There are
four different options to assess country risk: checklist approach,
Delphi technique, quantitative analysis and inspection visit. After
identifying the relevant country risk, an MNC will have to manage
the country risk by getting political risk insurance, engaging
and negotiating a legal agreement with the host government,
strategising its business and operations structure or creating a
healthy local image in the host country.
Self-test 4.1
1. Do you think that a proper country risk analysis can replace

a capital budgeting analysis of a project considered for a
foreign country? Explain.
2. List some forms of political risks other than a takeover of a

subsidiary by the host government. Briefly elaborate on how
each factor can affect the MNC. Subsequently, identify
common financial factors for an MNC to consider when
assessing country risk. Briefly elaborate on how each factor
can affect the risk to the MNC.
3. Describe the steps involved in assessing country risk once all

relevant information has been gathered.
Suggested answers to activities
Feedback
Activity 4.1
1. The most likely political factors are the blockage of fund

transfers or currency inconvertibility. The yuan is very volatile
and is sometimes subject to exchange rate control by the
Chinese government.
2. The economy of China is volatile. If the economic conditions

deteriorate, the demand for many products, including toys,
will decline.
Activity 4.2
1. The consultant used the Delphi technique.
2. The political factors seem to be a major concern relative to the

financial factors.
UNIT 4 15
4.2 Foreign Direct Investment

Objectives
1. Discuss the motivations of foreign direct investment.
2. Identify and discuss the various channels to invest aboard.
3. Analyse the benefit of international diversification.
Introduction
Direct foreign investment is another long-term perspective of international
financial management. It involves commitment of a longer time span. Direct
foreign investment is in real assets (e.g., plants, buildings or other physical assets)
by foreign companies. MNCs can engage in direct foreign investments in a host
country through various international methods discussed in Unit 1. Some of these
methods are joint ventures with other host country firms or MNCs, acquisitions
of host country firms and formation of fully-owned subsidiaries in a host country.
This section discusses the common motives for direct foreign investment and
illustrates the benefits of international diversification.
Motives
For an MNC, a simple motive for engaging in direct foreign investment is to
improve the bottom line and enhance shareholder wealth. The specific reasons
for direct foreign investments can be summarised as follows:
1. Attract new sources of demand
When an MNC’s sales are saturated in its home market, the further
growth of the company is limited by the local customer demand for its
products. A possible solution is to expand overseas. However, many of
these overseas markets may have trade restrictions that limit imports, or
the types of product require direct foreign investments. Therefore, MNCs
have to engage in direct foreign investments to penetrate these foreign
markets. An example is McDonald’s direct foreign investment in mainland
China. McDonald’s is a leading US fast-food chain. It came to a stage of
slow sales growth, since its market share in the US has already reached
its potential peak. In order to increase its sales, McDonald’s is expanding
overseas. Its strategy is very successful, since its restaurants in mainland
China are well received. The motivation for McDonald’s to do direct
foreign investment in mainland China is to attract new demand.
2. Enter new markets in which superior profits are possible
If other MNCs have proved that a foreign country is very profitable,

then another MNC may enter the new market to take advantage of the
superior profit. An example is Kentucky Fried Chicken. After McDonald’s
made a lot profit from its fast-food restaurants in mainland China,
Kentucky Fried Chicken followed suit by establishing subsidiaries in
China. The motivation for Kentucky Fried Chicken in direct foreign
investment is to enter new markets with potential superior profits.
3. Fully benefit from economies of scale
When an MNC expands its primary products in a new market, it allows

for increased production and possibly greater production efficiency in
its production facilities. For instance, the Single European Act removed
trade barriers in Western Europe. Colgate-Palmolive Company was then
able to establish new plants in Europe to massively produce toothpaste
and detergent. As a result, the company is able to enjoy economies of
scale. The motive of direct foreign investment of Colgate-Palmolive is to
benefit from economies of scale.
4. Use foreign factors of production
Labour and land costs vary a great deal in foreign countries compared
with those in the home country. For instance, the land and labour costs
in mainland China are substantially lower than those in Hong Kong.
This explains why many manufacturers in Hong Kong establish joint
ventures or subsidiaries in mainland China. Here, the motivation for
direct foreign investment is lower labour and land costs in mainland
China.
5. Use foreign raw material
Another major reason for direct foreign investment is to move closer to

the source of raw material. This is particularly common when the raw
material is bulky and expensive to transport, or it is critical to production.
Being closer to the source of raw materials minimises transportation cost
and guarantees a stable, on-time supply of raw material. An example is
US automobile tyre plants in Malaysia, which has an abundant supply of
rubber.
6. Use foreign technology
MNCs commonly acquire or are involved in joint ventures with foreign

companies in host countries to benefit from the technology. After the
acquisition of joint venture activities, an MNC is able to learn about
UNIT 4 17
the technology that can improve its production process throughout the
world. For instance, General Motors has a joint venture plant with Toyota
in California to manufacture cars. From the joint venture experience,
General Motors is able to learn Japanese automakers’ small car technology.
7. Exploit monopolistic advantages
An MNC is very motivated to establish a subsidiary in a market in which

competitors are unable to produce the identical product. A good example
is the US fast-food restaurant McDonald’s. Armed with the image of the
best US hamburgers, French fries and other fast food, the company set up
a fast-food business in China where it enjoys a monopolistic competitive
edge against local and even other foreign fast-food restaurants.
8. React to exchange rate movements
MNCs can establish subsidiaries in foreign markets in which the local

currency is weak but expected to strengthen over time. For instance,
Japanese automakers (Honda and Toyota) have increased their direct
foreign investment in the US since early 1990. This was the time when
the Japanese yen was strong relative to the US dollar. In the late 1990s, the
US dollar was continually strong relative to the Japanese yen. The earnings
from the cars produced and sold in the US would bring in US dollars that
can be remitted to Japan in exchange for more Japanese yen.
9. React to trade restrictions
MNCs may establish subsidiaries in foreign markets in which tougher

trade restrictions will adversely affect the MNCs’ export volume. For
example, Japanese car makers (Honda and Toyota) have established
assembly plants in the US to produce cars “locally” in the US so that
potential trade restrictions will not affect them.
10. Diversify internationally
An MNC may establish subsidiaries in countries whose business cycles

differ from those where existing subsidiaries are based. Then, if some of
the countries experience an economic downturn and a drop in sales, other
countries may be doing very well. Hence, the sales in countries where
economies are doing well will continue to grow. The MNC is very likely
to have sales in “good” countries offsetting the drop in sales in “poor”
countries. This is also in line with hedging economic risk exposure, as
discussed in Unit 3. For instance, during the 1997 Asian financial crisis,
if an MNC had a subsidiary in Thailand that engaged in local sales, then
the sales in Thailand would have plummeted because of a poor local
economy. However, if the MNC diversified across a number of countries,
the impact of sales drop in Thailand would be minimal.
How to invest abroad

There are many options how an MNC can invest abroad. This involves a
sequence of decisions regarding the control and ownership of the intellectual
property as well as the actual production facilities. Of course, the risk of
investing goes positively with higher degree of control as more control means
more commitment in terms of capital and resources and hence higher foreign
exposure. Figure 4.1 provides an overview of the various methods of foreign
entry strategies. The methods of overseas investment have been explained in
section 1.1 earlier.
Production at
Home Host
country country
Export No control Control
Partial Full
Licensing
ownership ownership
Acquisition
Joint Greenfield
of existing
venture investment
company
Figure 4.1 The various channels to invest abroad
Benefits of international diversification

When an MNC plan to expand its operation (or planning a project), it can expand
locally or in a foreign country. In addition to the motives just discussed, an MNC
should consider the benefits of international diversification if it chooses to expand
its operation in a foreign country. The benefits of international diversification
primarily come from the reduced variability of the returns of the new project
located in a foreign country with the returns of the existing projects in the home
country.
For instance, consider a Hong Kong-based toy company with 50% operations in
Hong Kong and 50% operations in the US. In 1999, Hong Kong experienced
economic recession and the demand for toys dropped. However, the US economy
was booming and the demand for toys was good. The Hong Kong-based toy
company is likely able to cushion the bad economy of Hong Kong, because its
US business is able to offset some of the losses in Hong Kong. If the Hong Kong-
UNIT 4 19
based toy company only operated in Hong Kong and relied on the local demand
for toys alone, the company would have a difficult time surviving a local economic
recession.
Characteristics of Characteristics of
proposed project proposed project if
if located in the located in a foreign
home country country
After tax mean expected return 25% 25%
Risk of the project as measured by 0.09 0.11
standard deviation of expected
return
Correlation of the proposed 0.80 0.02
project with the existing home
country business
Based on the table above, it is noted that the project can bring in a 25% return
for the MNC no matter where it is located. In addition, if the project is located
in the home country instead of a foreign country, the risk of the project (on a
stand-alone basis) is actually lower as measured by the standard deviation of the
project. However, when the project is integrated with the existing home country
business, it is another matter. Look at the risk level of ‘all operations’ of the MNC.
The risk of all operations using a portfolio variance concept can be examined as
follows:
σp2 = wA2 σA2 + wB2 σB2 + 2wA wB σA σB (CORRAB)
where σp = portfolio standard deviation of returns
wA = percentage of funds allocated to investment A (or all the existing operations)
σA = standard deviation of the returns of investment A (or the variance of the

returns of all existing operations)
wB = weight of the proposed investment B (or new projects either locally or in a

foreign country)
σB = standard deviation of the returns of investment B (or new projects either

locally or in a foreign country)
(CORRAB) = correlation coefficient of investment A and B.
Assume wA = 0.7, wB = 0.3 and σA = 0.1. That is, the existing operation in the
local country is 70% of the business and the proposed project would be 30% of
the business. The risk of the existing operations as represented by the standard
deviations of the returns is 0.1.
If the MNC decides to start the proposed project locally, then the overall risk level
of the MNC would be:
σp2 = (0.7)2 (0.1)2 + (0.3)2 (0.09)2 + 2(0.7)(0.3)(0.1)(0.9)(0.8) = 0.008653 or

σp = 0.0930215
If the MNC decides to start the proposed project in a foreign country, then the
overall risk level of the MNC would be:
σp2 = (0.7)2 (0.1)2 + (0.3)2 (0.11)2 + 2(0.7)(0.3)(0.1)(0.11)(0.02) = 0.0060814 or

σp = 0.0779833
Thus, the MNC would generate more stable returns if the MNC locates the
proposed project in a foreign country. This is the benefit of international
diversification.
Reading
Please read the following article in WOU MyDigitalLibrary,

E-course reserves. This reading material is extracted from Madura
(2012) International Corporate Finance, 11th edn, South-Western
(pages 422 – 423).
After reading, please do the following activity.
Activity 4.3
Nike is a well-known producer of athletic footwear. It has

continually pursued international business in Asia and Europe.
It attracted new sources of demand by consumers in foreign
countries. Nike also benefits from low labour costs by producing
some of its products in mainland China and other Southeast
Asian countries. It has also diversified so that it does not rely
solely on the demand in the US. Therefore, Nike’s overall cash
flows are less sensitive to economic conditions in any given
region.
Nike has plans for expanding its athletic footwear in Thailand.

What motives do you think have encouraged Nike to expand in
Thailand?
UNIT 4 21
Summary
This completes the section of Unit 4. In this section, you have

been introduced the concept of foreign direct investment, why
MNC are motivated to expand and invest their business abroad,
what are the ways they can invest abroad and the benefit of
diversifying their business internationally. The choice of which
methods to go abroad is largely depending on the degree of
control on the foreign business the MNC wish to withhold. This
is not an easy decision as more control also means more foreign
exposures the MNC need to bear.
Self-test 4.2
1. Describe some potential benefits to an MNC as a result of

Direct Foreign Investment (DFI). Elaborate on each type of
benefit. Which motives for DFI do you think encouraged
Nike to expand its footwear production in Latin America?
2. Packer, Inc., a U.S. producer of computer disks, plans to

establish a subsidiary in Mexico in order to penetrate the
Mexican market. Packer’s executives believe that the Mexican
peso’s value is relatively strong and will weaken against the
dollar over time. If their expectations about the peso value are
correct, how will this affect the feasibility of the project?
Explain.
3. Bear Co. and Viking, Inc., are automobile manufacturers that

desire to benefit from economies of scale. Bear Co. has decided
to establish distributorship subsidiaries in various countries,
while Viking, Inc., has decided to establish manufacturing
subsidiaries in various countries. Which firm is more likely to
benefit from economies of scale?
Suggested answers to activity
Feedback
Activity 4.3
First, Thailand offers additional sources of demand for Nike

products. Second, Thailand is able to produce Nike products
at relatively low cost, since Thailand has low wages (and the
athletic footwear production is labour intensive). Third, Nike may
benefit from economies of scale by producing a large amount and
exporting the additional shoes for sale in nearby countries. Fourth,
the expansion into Thailand allows Nike to further diversify its
business internationally.
UNIT 4 23
4.3 Multinational Capital Budgeting

Objectives
1. Analyse how multinational capital budgeting can be applied to determine

whether an international project should be implemented.
2. Identify key steps in the process of capital budgeting.
3. Apply various long-term financing tools in decision making.
Introduction
The previous two sections on country risk analysis and direct foreign investment
provide a macro perspective of long-term international financial management.
The country risk analysis is highly aggregate and is applied to the international
business environment of an MNC. This section focuses on the micro perspective
of long-term financial management. From now on, the analysis is at the corporate
level.
The theoretical framework of a basic capital budgeting process follows the

following steps:
1. Identifying the initial capital to be invested.
2. Estimating cash flows to be used over time.
3. Identifying the appropriate discount rate.
4. Applying decision criteria to evaluate the acceptability and ranking of

potential projects.
This section identifies additional considerations in multinational capital budgeting

compared to domestic capital budgeting. Differences exist between the capital
budgeting for domestic and foreign projects. For domestic projects, it is not
necessary to consider exchange rate fluctuations, foreign country inflation, foreign
financing arrangements, foreign country’s blocked funds policy, uncertain salvage
value in a foreign country, impact of project on prevailing cash flows and host
government incentives. These additional considerations are either explained briefly
or illustrated with the example. You should read the following subsection to be
familiar with some concepts and examples pertaining to multinational capital
budgeting.
The perspective of multinational capital budgeting

The perspective of multinational capital budgeting is one issue that need to
be pre-determine as the net after-tax cash flow can differ substantially under
the different perspective; i.e., those from the subsidiary point of view versus
those of the parent company. The perspective of subsidiary is important as it
is the subsidiary that is responsible for managing the project. However, if the
project is financed by the parent company, then it is clearly the parent company
perspective is more relevant. There differences are due to a few reasons:
1. Tax differentials: High taxes in the home country automatically require

high returns to be expected from any project undertaking by the
subsidiary, unless the future profit is not to be remitted to the parent
company.
2. Restricted remittances: If the foreign government has a rule that require

the subsidiary to retain high proportion of subsidiary’s profit in the host
country, it is better than for the subsidiary to seek for local financing,
either partially or fully.
3. Excessive remittances: If high administrative fees are to be paid to the

parent company due to centralised management structure, the expenses
on any projects taken by the subsidiary will be high. Then it is not
feasible to adopt the subsidiary’s perspective.
4. Exchange rate movements: The more volatile the exchange rate, the
higher the risk of not getting the forecasted cash flow that assessed by
the subsidiary.
Inputs used for multinational capital budgeting

Multinational corporations evaluate international projects (i.e., projects located
in foreign countries) by using multinational capital budgeting. Proper use of
multinational capital budgeting ensures an MNC accepts international projects
worthy of implementation. The most popular form of capital budgeting technique
(as suggested by other finance courses) is net present value calculation. Essentially,
when making a capital budgeting decision, a company determines the project’s
net present value by estimating the present value of the project’s future cash
flows and subtracting the initial expenditure for the project. Multinational
capital budgeting uses a similar process in evaluating international projects. The
following is a list of inputs to consider when multinational capital budgeting is
conducted:
1. Initial investment of the project: The bigger the initial investment, the less
likely the project will be undertaken.
2. Consumer demand for the products or services produced: The higher the
consumer demand, the more likely the project will be undertaken.
UNIT 4 25
3. Price of the products or services produced: The higher the price the products
or services could command, the more likely the project will be undertaken.
4. Variable cost of the project: The higher the variable cost, the less likely the
project will be undertaken.
5. Fixed cost of the project: The higher the fixed cost, the less likely the project
will be undertaken.
6. Project lifetime: The longer the lifespan of the project, the less likely it will
be undertaken.
7. Salvage value of the project: The lower the salvage value of the project, the
less likely it will be undertaken.
8. Fund-transfer restriction of the host country: The stricter fund transfer

restriction, the less likely the MNC is to undertake a project there.
9. Tax laws of the host country: The heavier the tax of the host country on
MNC, the less likely MNC is to undertake a project there.
10. Exchange rate movements: The more erratic the exchange rate with the
host country, the more the uncertainty to the capital budgeting of MNC.
11. Required rate of return of the project: The higher the required rate of return
from the project, the fewer the projects in the host country will qualify.
From the above list, you see inputs that are not explicitly to be considered in
a domestic capital budgeting. For instance, there will be neither consideration
of fund-transfer restriction nor exchange rate movements in a domestic capital
budgeting consideration. In addition are some possible changes of the values of
inputs because of the international nature of the capital budgeting. For instance,
the project lifetime may be longer or shorter, the salvage value of the project
may be larger or smaller and the required rate of return of the project may be
higher or lower. Therefore, multinational capital budgeting is more complex than
domestic capital budgeting. The capital budgeting process will be illustrated with
an example in the following subsections.
Factors to consider in multinational capital budgeting

The following list helps construct a capital budgeting spreadsheet model in
evaluating multinational projects. It will be easier for you to understand the
spreadsheet model if the additional factors are discussed.
1. Exchange rate fluctuations
Capital budgeting is a multi-year process. Over the life of the project, the
exchange rate may change. It is certainly not an easy task to accurately
forecast exchange rate changes. A common approach would be running
the multinational capital budgeting analysis with a strong host country
currency as well as a weak host country currency assumption. If the
multinational capital budgeting analysis yields similar results in both, the
project is worthwhile to pursue.
2. Inflation
Inflation affects the variable cost and price components in the

multinational capital budgeting analysis. Accordingly, the net cash flows
to the parent company may change. Again, a common way to examine
the issue is to run one or more scenarios and see how the net cash flows
change. A desirable project would yield stable results.
3. Financing arrangements
One major difference between multinational capital budgeting vis-à-vis

domestic capital budgeting is the wide availability of financing in the
host country’s lenders. In general, if the parent company’s required rate
of return exceeds the financing rate from the host country’s lenders,
it would be more feasible for the subsidiary to obtain host country
financing.
4. Blocked funds
Sometimes, the host country may block funds that the subsidiary
attempts to send to the parent company. For example, some countries
may require that earnings generated by the subsidiary be reinvested locally
for at least three years before they can be remitted overseas. These rules
may affect accepting/rejecting a decision.
UNIT 4 27
5. Uncertain salvage value
The salvage value of a project is affected by the exchange rate, the host
country’s economic condition when the project is disposed. Again, a
general approach is to conduct scenario analysis to see the sensitivity of
the net cash flows given various reasonable possible changes of salvage
value.
6. Impact of project on prevailing cash flows
A project may affect the existing cash flows of other projects. When
estimating the cash flows, you need to consider the possible side impacts
of the new project to the existing project’s net cash flows.
7. Host government incentives
Some host countries may offer incentives to attract foreign business.

Any of these incentives should be incorporated in the capital budgeting
process.
The process of multinational capital budgeting

Similar to your earlier finance courses, such as BBF 302/05 Financial Management
and Analysis, there are several key steps to conducting capital budgeting analysis.
These steps are reviewed before an example is given. The steps are:
1. Estimate future after-tax cash flows.
2. Forecast exchange rate and adopt an appropriate discount.
3. Calculate the Net Present Value (NPV).
Example 1
XYZ Company presently has no subsidiary in Switzerland. The company is

considering establishing a subsidiary there to produce TV sets. The capital
budgeting manager of the company supplies the following information:
• The initial investment of plant and equipment for the project is SF30m.
• XYZ needs to borrow SF20m for working capital. The money will be
borrowed from a Swiss bank at 14% interest and a three-year term. XYZ
only pays interest in the three-year period and the principal of SF20m will
be paid in a lump sum in three years.
• The project will last only three years. After that, it will be sold to another
local firm.
• The price, demand and variable cost are given in the following table:
Price
Year Demand Variable cost per unit
(SF)
1 500 40,000 30
2 511 50,000 35
3 530 60,000 40
• The fixed cost is SF6m per year.
• The exchange rate of the Swiss franc is expected to be $0.92/SF, $0.94/SF

and $0.96/SF at the end of Year 1, Year 2 and Year 3.
• Switzerland has a 30% tax on income. In addition, the Swiss Government

imposes a 10% tax on earnings remitted by a subsidiary to its parent
company.
• All cash flows received by the subsidiary are to be sent back to the parent
company.
• The plant and equipment will be depreciated over three years, using
straight-line depreciation.
• The required rate of return is 20%
What is the net present value of the project? Should the company establish the
subsidiary in Switzerland?
Tips: Recall the net present value formula as follows:

n
CFt SVn
NPV = −IO + ∑ +
t=1 (1 + k)t (1 + k)n
where
IO = initial outlay
CF = cash flow in period t

UNIT 4 29
SV = salvage value
k = required rate of return on the project
n = lifetime of the project (number of periods)
Solution
Construct a capital budgeting spreadsheet model as follows:
Step 1: Estimate after-tax cash flows:
Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60000

2. Price per unit in SF 500 511 530
3. Total revenue = (1) × (2) in SF 20,000,000 25,550,000 31,800,000
4. Variable cost per unit in SF 30 35 40
5. Total variable cost = (1) × (4) 1,200,000 1,750,000 2,400,000
6. Fixed cost in SF 6,000,000 6,000,000 6,000,000
7. Interest exp. of Swiss loan in SF 2,800,000 2,800,000 2,800,000
8. Depreciation exp. in SF 10,000,000 10,000,000 10,000,000
9. Total expense = (5) + (6) + (7) + (8) 20,000,000 20,550,000 21,200,000
10. Earnings before tax = (3) − (9) 0 5,000,000 10,600,000
11. Swiss tax at 30% 0 1,500,000 3,180,000
12. Earnings after tax = (10) − (11) 0 3,500,000 7,420,000
13. Net cash flow = (12) + (8) 10,000,000 13,500,000 17,420,000
14. SF remitted to parent co. before 10,000,000 13,500,000 17,420,000
withholding tax = (13)
15. Swiss withholding tax at 10% 1,000,000 1,350,000 1,742,000
16. SF remitted to parent co. = (14) − (15) 9,000,000 12,150,000 15,678,000
Step 2: Forecast exchange rates and adopt an appropriate discount rate
Year 1 Year 2 Year 3
17. Exchange rate of SF $0.92/SF $0.94/SF $0.96/SF

18. Cash flow to parent = (16) × (17) 8,280,000 11,421,000 15,097,914
19. PV of parent cash flows at 20% discount 6,900,000 7,931,250 8,737,219
rate
Step 3: Calculate the Net Present Value (NPV)
The net present value = −30m + 3.9m + 4.56m + 5.08m = −16.46m.
Please note that the salvage value is zero. Since the net present value is negative,
XYZ should not establish the subsidiary in Switzerland. Note that tax plays an
important role in the capital budgeting analysis. In lines 11 and 15, the Swiss tax
on earnings and withholding tax reduce the Swiss francs remitted to the MNC
parent. Clearly, different countries may have different taxes and therefore the NPV
calculated can be different even if all other information is the same.
The exchange rates of Swiss francs (in line 17) over the three years are forecast
rates. The capital budgeting manager will likely use the concepts in Unit 2 (i.e.,
purchasing power parity, covered interest parity and international Fisher effect)
to get some ideas of the forecast. Another common approach is using the forward
rate quoted by a commercial bank as the exchange rate forecast.
The discount rate of 20% (in line 19) is also called the cost of capital. In general,
the cost of capital consists of two factors: a base rate or the opportunity cost of
the capital (e.g., the financing rate an MNC can obtain through international
borrowing); and a risk premium that reflects the riskiness of the project. At the
beginning of this unit, country risk analysis was discussed. If it is determined
that the project country has a high country risk, then the discount rate should
be adjusted upwards in the capital budgeting analysis or vice versa. Obviously, an
MNC would try to lower its cost of capital in dealing with multinational capital
budgeting.
There are two approaches to lower cost of capital. First, the MNC can issue
foreign bonds to lower its borrowing cost (i.e., lower the opportunity cost of
capital). Second, the MNC can through international diversification lower the
riskiness of the project. Both approaches are discussed in the next section.
Reading
Please read the following article in WOU MyDigitalLibrary,

E-course reserves. This reading material is extracted from Martin
Holmen and Bengt Pramborg (2009) Capital Budgeting and
Political Risk: Empirical Evidence, Journal of International Financial
Management and Accounting.
UNIT 4 31
Long-term financing
Long-term financing is another important element in multinational financial
management. An MNC needs funding to finance its projects. In the previous
section (multinational capital budgeting), the project needs DM30m as the initial
investment. Where does the DM30m come from? The MNC usually borrows money
to fund long-term projects. An MNC has more choices than a ‘domestic’ company
in long-term financing because an MNC has a wider network of operations and
is able to assess international lenders. It can borrow money in its home country
or other foreign countries. This section discusses all of these choices. Since we are
confined to long-term financing (short-term financing will be discussed in Unit 5),
we assume that MNCs issue long-term bonds to borrow money either locally or in
foreign countries. Assuming other things being equal, it is always cheaper to borrow
money by issuing bonds than by borrowing money from financial institutions.
Long-term financing decisions

Long-term financing decisions are influenced by different interest rates in
different countries as well as the percentage change in the exchange rate of the
currency borrowed over the life of the loan. In general, an MNC can either
borrow money locally in the US (dollar-denominated bonds) or borrow money
in a foreign country (foreign currency denominated bonds). Because of exchange
rate changes, there is no guarantee that foreign currency denominated bonds will
be less costly than US dollar-denominated bonds even if the foreign currency
bonds have lower yields. To make a long-term financing decision, the MNC
must:
1. Determine the amount of funds needed.
2. Forecast the price at which it can issue the bond.
3. Forecast the periodic exchange values for the currency denominating the
bond.
All three procedures would help determine the financing cost of the bond, which
can be compared with the financing costs the MNC would incur using its home
currency. Let us look at Example 2.
Example 2
An MNC needs to borrow $1,000,000 over a three-year period. The following

information is provided by the treasurer of the MNC:
• The MNC believes that it can sell dollar-denominated bonds at par value
($1,000) if it provides a coupon rate of 14%. The coupon interest will be
paid annually.
• The MNC can also issue Singapore dollar-denominated bonds in the

Eurobond market. It would convert its borrowed Singapore dollars to US
dollars to use as needed.
• The MNC believes that it can sell the Singapore dollar-denominated bonds
at par with a coupon rate of 10%.
• If the MNC decides to borrow in Singapore dollars, it would need to

obtain Singapore dollars annually to make coupon payments.
• The current exchange rate is $0.50/S$.
• The exchange rate of the Singapore dollar is analysed in three different

scenarios:
Singapore dollar End of End of End of exchange

Year 1 Year 2 Year 3 rate
Stable relative to dollar $0.7/S$ $0.7/S$ $0.7/S$
Strong relative to dollar $0.75/S$ $0.8/S$ $0.85/S$
Weak relative to dollar $0.68/S$ $0.66/S$ $0.6/S$
What are the financing costs of using Singapore dollar-denominated bonds over
the three-year period under the different exchange rate scenarios?
UNIT 4 33
Solution
1. Stable exchange rate (at $0.5/S$)
• The MNC needs to issue S$2,000,000 bonds in order to receive

$1,000,000 in the beginning of Year 1.
• The annual financing cost of using Singapore dollar-denominated

bonds is 10%, which is illustrated in the following table.
• Using Singapore dollar-denominated bonds is cheaper.
End of year cash flow to bondholders
End of Year 3 Annual

End of Year 1 End of Year 2
(interest plus financing
(interest only) (interest only)
principal) cost
Dollar-denominated $1,000,000 × 14% $1,000,000 × 14% $1,000,000 × 14% 14%
bonds at 14% = $140,000 = $140,000 + $1,000,000 =
coupon rate $1,140,000
Singapore dollar- $2,000,000 × 10% $200,000 $2,200,000 
denominated = S$200,000
bonds at 10%
Exchange rate $0.7/S$ $0.7/S$ $0.7/S$ 
Payments in dollars $140,000 $140,000 $1,540,000 25%
Note: the annual financing cost is calculated as solving the discount rate (r) of the following
equation. $1,000,000 = $100,000/(1 + r) + $100,000/(1 + r)2 + $1,100,000/(1 + r)3
2. Strong Singapore dollar (exchange rate goes up from $0.5/S$ to $0.65/S$)

$1,000,000 in the beginning of Year 1.

bond is 20.11%, which is illustrated in the following table.
• Using Singapore dollar-denominated bonds is expensive.


principal) cost
bonds at 14% = $140,000 = $140,000 + $1,000,000 =
Singapore dollar- S$2,000,000 × 10% S$200,000 S$2,200,000 
bonds at 10%
3. Weak Singapore dollar (exchange rate drops from $0.5/S$ to $0.4/S$)

$1,000,000.

bonds is 2.4%, which is illustrated in the following table.
• Using Singapore dollar-denominated bonds is the cheapest.

principal) cost
bonds at 14% = $140,000 = $140,000 + $1,000,000 =
Singapore dollar- S$2,000,000 × 10% S$200,000 S$2,200,000 
bonds at 10%
From the above example, it is clear that whether an MNC goes for foreign
financing depends on the exchange rate movement. The example assumes no
restriction exists on the remittance (e.g., withholding tax) of the borrowed money
to other countries. If there is restriction on money remittance, then it is unlikely
that MNCs will borrow money from that host country.
UNIT 4 35
Activity 4.4
Hong Kong Star is considering issuing a Singapore dollar-

denominated bond at its present coupon rate of 7%. It is attracted
to the low financing rate since Hong Kong dollar-denominated
bonds issued in Hong Kong would have a coupon rate of 12%.
The bond has a four-year maturity and could be issued at par value.
Hong Kong Star needs to borrow HK$80m. The current exchange
rate is HK$5/S$. Therefore, it will either issue Hong Kong dollar
bonds with a par value of HK$80m or bonds denominated in
Singapore dollars with a par value of S$20m.
Hong Kong Star has forecasted the exchange rate in the next four
years as follows:
End of year Exchange rate
1 HK$5.4/S$
2 HK$5.8/S$
3 HK$6.0/S$
4 HK$5.5/S$
Determine the expected annual cost of financing with Singapore

dollars.
Financing with fixed rate and floating rate bonds

The previous section discusses long-term financing with fixed rate bonds.
Essentially, the coupon interest is fixed (over the years in the above example). In
reality, because of changing international interest rates, international investors
(potential bond holders) are more interested in floating rate bonds, i.e., the ones
that have coupon rate indexed with a commonly accepted interest rate. The most
commonly used accepted interest rate for international lending is the London
Interbank Offer Rate (LIBOR), used by international banks that lend funds to
each other. For instance, the coupon rate of a Singapore dollar-denominated
bond may be LIBOR plus 1%. If the current LIBOR is 8%, then the coupon
rate of the bond becomes 9%. Obviously, the floating rate bonds add another
uncertainty to the issuer (an MNC) in cash flow estimation. Nevertheless, an MNC
usually finds that it should consider long-term financing with foreign currencies.
Web Reference
For more information on the floating rate bonds, please refer to

http://www.investopedia.com/terms/f/floating-rate-fund.asp
Equity financing
Another option for an MNC to raise capital is to obtain equity financing from a
foreign country. In this case, the MNC issues common stock in raising capital with
the hopes to attract foreign investors buying its stock. In return, the MNC obtains
foreign funds to support its home or foreign activities. For instance, a few China
companies are trying to do initial public offerings (IPOs) in the US. The equity
financing usually requires very careful planning and follows very tight regulations.
Summary
This completes the final section of Unit 4. By now, you should

have a clear view of the distinction between a local and a
multinational capital budgeting processes. The end result of
capital budgeting will differ under the perspective of the parent
company and the perspective of the subsidiary. These are
reflected in the added input consideration when dealing with
multinational capital budgeting as compared to local or home
country capital budgeting. Capital budgeting is more difficult
to be estimated compared to currency risk and political risk.
One option to reduce currency exposure in multinational capital
budgeting is to adopt long-term financing. Another option is to
issue equity to foreign investors.
UNIT 4 37
Self-test 4.3
1. Sam Lee’s business, the Oriental Earring Company, continues

to grow. His primary product is oriental earrings, which he
exports to a distributor in Britain. The business is good and
earnings are increasing. Sam is considering to establish a
subsidiary in Britain to produce the earrings there instead of
in his small plant in Hong Kong. What are the advantages
and disadvantages for Sam to establish a firm in Britain?
2. Assume that a Hong Kong firm was considering a project in

Thailand to be financed with Hong Kong dollars. All cash
flows generated from the project are to be reinvested in
Thailand for several years. Explain how the Asian financial
crisis would have affected the expected cash flows of this
project and the required rate of return on the project. If the
cash flows were to be remitted to the Hong Kong parent firm,
explain how the Asian financial crisis would have affected the
expected cash flows of this project.
3. XYZ is a Hong Kong-based chemical company that has

attempted to capitalise on new opportunities to expand in
Malaysia. The production costs in Malaysia are only 25% of
the cost of those in Hong Kong. Furthermore, the demand
for chemicals in Malaysia is strong. XYZ penetrated Malaysia
by purchasing a 60% stake of ABC, a Malaysian firm that
produces chemicals. Should XYZ finance its investment in the
Malaysian firm by borrowing Hong Kong dollars from a
Hong Kong bank which is then converted into ringgit (the
Malaysian currency), or by borrowing ringgits from a local
Malaysian bank? What information do you need to know to
answer this question?
Suggested answers to activity
Feedback
Activity 4.4
End of year 1 End of year 2 End of year 3 End of year 4
S$ payment S$1.4m S$1.4m S$1.4m S$21.4m

Exchange rate HK$5.4/S$ HK$5.8/S$ HK$6.0/S$ HK$5.5/S$
HK$ payment HK$7.56m HK$8.12m HK$8.4m HK$117.7m
The annual cost of financing with Singapore dollars is determined

as the discount rate that equates the Hong Kong dollar payments
resulting from payments on the Singapore dollar-denominated
bond to the amount of Hong Kong dollars borrowed. Using a
financial calculator or a spreadsheet program, this discount rate
is 17.19%, which is higher than the 12% associated with issuing
Hong Kong dollar-denominated bonds.
UNIT 4 39
Summary of Unit 4
Summary
Building on what you have studied in the first three units,

this unit has discussed issues related to the long-term aspect of
financial management within an MNC. Both macro and micro
perspectives were discussed. The macro perspective covers issues
such as country risk analysis and foreign direct investment.
The micro aspect includes multinational capital budgeting and
long-term financing with foreign currencies. The macro aspect
essentially explains the economic environment an MNC operates.
The micro aspect focuses on the issues at the corporation level.
Obviously, both macro and micro levels of long-term aspects
of multinational financial management are important to the
operations of an MNC.
The main points in this unit are:
1. Country risk is defined as the potential adverse impact of a

country’s environment on the MNC’s cash flows.
2. Country risk has two components: political risk and financial

risk. The sources of country risk are from political aspect,
government structure, economic aspect and social aspect.
3. There are two types of country risk assessment. A macro

assessment considers all scenarios that affect country risk. It is
an overall assessment of the business environment of a
particular country. A micro assessment considers all scenarios
that affect an industry or a firm operating in a particular
country.
4. There are four systems available in assessing country risk:

(1) checklist approach; (2) Delphi technique; (3) Quantitative
analysis; and (4) Inspection visit. They can be conducted
independently or in a combination.
5. There are a few approaches to minimise country risk include:

(1) take precaution policy like purchase political risk insurance;
(2) reach agreement with the host government; (3) strategies
its business and operation structure; and (4) commit social
obligation to the local communities.
6. The motive for engaging in direct foreign investment is to

improve the bottom line and enhance shareholder wealth.
7. The specific reasons for direct foreign investments include

attract new sources of demand, enter new markets in which
superior profits are possible, fully benefit from economies of
scale, use foreign factors of production, use foreign raw
material, use foreign technology, exploit monopolistic
advantages, react to exchange rate movements and react to
trade restrictions.
8. Direct foreign investment can be engage in various methods,

including joint ventures, acquisitions and fully-owned
subsidiaries depending on the degree of control the parent
company wish to assume.
9. The benefits of international diversification primarily come

from the reduced variability of the returns.
10. The framework of capital budgeting are: (1) identify the initial
capital to be invested; (2) estimate cash flows to be used over
time; (3) identify the appropriate discount rate; (4) applying
decision criteria to evaluate the acceptability and ranking of
potential projects.
11. Multinational capital budgeting need to consider exchange

rate fluctuations, foreign country inflation, foreign financing
arrangements, foreign country’s blocked funds policy,
uncertain salvage value in a foreign country, impact of project
on prevailing cash flows and host government incentives.
12. The perspective of multinational capital budgeting, either

from the subsidiary or the parent company, need to be
predetermined. These are affected by (1) tax differentials;
(2) restricted remittances; (3) excessive remittances; and
(4) exchange rate movements.
13. The factors to consider in multinational capital budgeting

are: (1) exchange rate fluctuations; (2) inflation; (3) financing
arrangements; (4) blocked funds; (5) uncertain salvage value;
(6) impact of project on prevailing cash flows; (7) host
government incentives.
14. Long-term financing can reduce currency exposure in

multinational capital budgeting.
15. Issuing foreign equity to is another option to attract more

liquidity.
UNIT 4 41
Suggested Answers to Self-tests
Feedback
Self-test 4.1
1. No. Country risk analysis is not intended to estimate all

project cash flows and determinate the present value of these
cash flows. It is intended to identify forms of country risk and
their potential impact. If the potential impact is material,
then the MNC may need to adjust the discount rate used in
capital budgeting, since the required rate of return would be
higher. This is important information for capital budgeting
but is not a substitute for capital budgeting.
2. Forms of political risk include the possibility of (1) blocked

funds, (2) changing tax laws, (3) public revolt against the
firm, (4) war and (5) a changing attitude of the host
government toward the MNC. The forms of country risk
mentioned here can cause reduced demand for the
subsidiary’s product, higher taxes, or restrictions of fund
transfers.
3. First, a rating must be assigned to each factor. Then, a weight

must be assigned. Finally, the weighted ratings can be
consolidated to derive an overall political risk and financial
risk rating and (if desired) an overall country risk rating.
Self-test 4.2
1. Regarding Nike’s motives, Latin America offers additional

sources of demand, as Latin American consumers have shown
an interest in Nike footwear (this is partially due to increased
marketing targeted to Latin American markets). Second,
Nike may be able to produce their athletic footwear at
relatively low costs in some Latin American countries, as the
production is labor-intensive and wages are low. Third, Nike
may benefit from economies of scale by producing a large
amount and exporting the additional shoes for sale to nearby
countries. Fourth, the expansion into Latin America allows
Nike to further diversify its business internationally.
2. If the peso’s value is relatively strong now, Packer Inc. will

incur high costs of establishing a Mexican subsidiary. In
addition, if the peso weakens, future remitted earnings by the
subsidiary to the parent will be converted to fewer dollars.
Packer will be adversely affected by the exchange rate
movements (although the project may still be feasible).
3. Bear Company is likely to benefit because it is maintaining

all of its manufacturing in one area. If Viking Inc. spreads
its production facilities, it will incur higher fixed costs of
machinery.
Self-test 4.3
1. Advantages:
• Most of the expenses of the subsidiary would be

denominated in same currency (pounds) as the currency
that is received when selling the earrings.
• There would be fewer delays when transporting the

earrings from point of production to point of distribution.
• Sam can avoid potential trade restrictions by producing

the earrings in the country where they are to be sold.
Disadvantages:
• Sam would incur new expenses associated with the new

subsidiary.
• Sam may not be able to monitor the subsidiary’s business

himself.
2. The Asian financial crisis would have reduced local currency

cash flows because of a weak Thai economy. Then, the cash
flows from the project would have been remitted at weak
bhat exchange rates, which would reduce the Hong Kong
dollar cash flows received by the Hong Kong parent firm.
The required rate of return would be higher to capture the
higher degree of uncertainty surrounding future cash flows.
UNIT 4 43
3. XYZ should consider interest rates in Hong Kong versus the

interest rate when borrowing ringgits. It would also need to
consider the potential change in ringgit exchange rate against
the Hong Kong dollar. If it finances the project in Hong Kong
dollars, it is more exposed to exchange rate risk, because the
funds would be remitted to the Hong Kong bank before
paying interest expenses on the loan. Conversely, if it finances
the project in ringgit, it could use some of its local funds to
pay off its interest expenses before remitting any funds to
Hong Kong. Another reason for borrowing from a local
Malaysian bank is the bank may help XYZ avoid any
excessive regulatory restrictions that could be imposed on the
foreign firm in the chemical industry. These potential
advantages of borrowing locally must be weighed against the
potentially higher interest rate when borrowing locally.
UNIT 4 45
References
Madura, J (2009) International Corporate Finance, 9 th edn, USA: Thomson
Learning.
Business Monitor International http://www.businessmonitor.com/ (Accessed

24 May 2010)
Countryrisk.com https://www.countryrisk.com/ (Accessed 24 May 2010)
Economist Intelligence Unit http://store.eiu.com/product/60000206.html?

ref=Products (Accessed 24 May 2010)
Political Risk Services Group http://www.prsgroup.com/ (Accessed 24 May 2010)

International Financial MGMT U4

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UNIT 4 i

Long-term aspects of international financial management

EXTERNAL COURSE ASSESSOR

© 2010 Wawasan Open University

First revision 2015

Wawasan Open University [DU013(P)]

4.1 Country risk analysis 3

Rationale for country risk analysis 4

Political risk and financial risk factors 6

Techniques of country risk assessment 9

How to manage country risks? 11

Suggested answers to activities 14

4.2 Foreign direct investment 15

How to invest abroad 18

Benefits of international diversification 18

Suggested answers to activity 22

4.3 Multinational capital budgeting 23

The perspective of multinational capital budgeting 24

Inputs used for multinational capital budgeting 24

Factors to consider in multinational capital budgeting 26

The process of multinational capital budgeting 27

Long-term financing decisions 31

Financing with fixed rate and floating rate bonds 35

Suggested answers to activity 38

Suggested answers to self-tests 41

I n Unit 1, you studied the basics of a multinational corporation (MNC),

Unit 4 focuses on the issues related to the long-term aspect of financial

1. Conduct country risk assessment.

2. Discuss the management of country risk.

3. Critically discuss foreign direct investment.

4. Apply the principles of multinational capital budgeting on international

5. Discuss the various types of long-term financing tools.

4.1 Country Risk Analysis

1. Define country risk analysis and discuss its rationale.

2. Identify techniques of country risk assessment.

3. Discuss methods to manage country risk.

Country risk is a long-term analysis, since it usually involves the country’s

Rationale for country risk analysis

2. An MNC can use country risk analysis to screen countries before it

Among some of the sources of uncertainty are:

3. Occupation of foreign power.

7. Takeover by extremist government.

9. Change in currency policy say from flexible to fixed regimes.

10. Capital control (transfer risk).

11. Force reinvestment (locally).

12. Trade restrictions.

13. Protectionism on certain industry for national security.

14. Allowable ownership structure.

15. Government debt default.

19. Weak property right protection.

20. Financial crisis in host market.

21. Recession in host market.

22. Credit squeeze.

23. Unstable macroeconomic fundamentals.

25. Loose corporate governance in the foreign subsidiaries.

26. Weak banking system.

27. Labour strike.

28. Human resource norms.

29. Local consumer attitudes.

One example of the importance of country risk is from a US-based MNC,

Political risk and financial risk factors

Attitude of consumers in the host country

Attitude of host government