Introduction to International

Financial Management
 Multinational Corporation (MNC)
• MNC is defined as firm that engages in some
form of international business
• Goal of Finance Manager in MNC: Maximizing
shareholder’s wealth
 WHY STUDY INTERNATIONAL
FINANCE?
• In today's world finance cannot be anything but
international
• Enormous growth in the volume of international
trade
• Cross border capital flows and, in particular,
direct investment have also grown enormously
• Veritable revolution has been taking place in the
money and capital markets around the world
• Liberalization, deregulation, integration and
innovation have created a giant international
financial market which is extremely dynamic and
complex
Contd…
WHY STUDY INTERNATIONAL
FINANCE?
• Multilateral negotiations regarding phased removal of trade
barriers have made considerable progress and WTO had
emerged as a meaningful platform
• Post World War II, World trade has grown faster than World
GDP
• Almost all countries getting integrated with the global
economy
• Indian economy needs substantial amounts of foreign
capital to augment domestic savings
• Technology up-gradation in India will require continuing
import of foreign technology, hardware and software
• India’s increasing recourse to commercial borrowings and
direct and portfolio investments by nonresidents
Contd…
WHY STUDY INTERNATIONAL
FINANCE?
• The efforts of Indian companies to diversify into exports of
engineering equipment and turnkey projects will have to
be supported by the ability to offer long term financing to
buyers
• A number of companies particularly in the Indian IT sector
have begun venturing abroad for strategic reasons either
as partners in joint ventures or by establishing foreign
subsidiaries
• India's growing dependence on international financial
markets
– Debt
– Equity
– FPI investment
Contd…
WHY STUDY INTERNATIONAL
FINANCE?
• Indian companies have also been venturing
abroad for setting up joint ventures and wholly
owned subsidiaries
• For those who are willing to master its
complexities the global financial market provides
endless opportunities for creative financial
management; for the unwary, it is a minefield
• Finance managers must come to grips with the
conceptual foundations and practical issues of
instruments and markets
 GLOBALIZATION
On or Off?

§ Economic "globalization" refers to the increasing

integration of economies around the world, particularly
through the movement of goods, services, and capital
across borders. The term sometimes also refers to the
movement of people (labor) and knowledge
(technology) across international borders.
§ The term "globalization" began to be used more
commonly in the 1980s, reflecting technological
advances that made it easier and quicker to complete
international transactions—both trade and financial
flows.
Contd…

GLOBALIZATION
On or Off?
§ There are countless indicators that illustrate how goods, capital,
and people, have become more globalized.
§ The value of trade (goods and services) as a percentage of world
GDP increased from 42.1 percent in 1980 to 58.24% percent in
2019.
§ Global exports were 334 billion dollars in 1971 while in 2021 the
volume was $28.5 trillion dollars.
§ The global Foreign direct investment increased from $204 bn
1990 to nearly $1.6tn in 2021.
§ The share of developed economies in global outward FDI flows
rose from 52.3 per cent in 2020 to 74.3 per cent in 2021, while the
share of developing economies dropped from 47.7 per cent to
25.7 per cent.
§ Developed Europe was the largest source of global FDI outflows
(32.3 per cent), followed by the developed economies in the
Americas (28.9 per cent).
Contd…

GLOBALIZATION
On or Off?
§ The ratio of global debt outstanding to world GDP, increased
from roughly 170 percent in 1990 to 256 percent in 2020.
§ For a while after the 2007-08 financial crisis there was a
slowdown and reversal but the uptrend is back by now.
§ The number of migrant workers has increased from 78
million people (2.4 percent of the world population) in 1965
to 150 million people (2.9 percent of the world population)
in 2000, to 214 million (3.1%) in 2009 to 258 million in 2017
(4.2% of world population)
 THE FINANCE FUNCTION
• The finance function in a firm can be
conveniently divided into two sub-functions
viz. accounting and control and treasury
management
• Decisions taken by the treasurer have
implications for the controller and vice versa
Contd…

THE FINANCE FUNCTION

 THE EMERGING CHALLENGES
§ To keep up-to-date with significant environmental changes
and analyze their implications for the firm.
§ To understand and analyze the complex interrelationships
between relevant environmental variables and corporate
responses - own and competitive - to the changes in them.
§ To be able to adapt the finance function to significant
changes in the firm's own strategic posture.
§ To take in stride past failures and mistakes to minimize their
adverse impact.
§ To design and implement effective solutions to take
advantage of the opportunities offered by the markets and
advances in financial theory.
 Key questions of International
Financial Management
• Where in the world we should locate our
plants?
• Which global market should we seek to
penetrate?
• Where in the world should we raise our
financing?
 Difference between Domestic and International
Financial Management
Concept International Domestic
Culture, history and Each foreign country is Each country has a known
Institutions unique and not always base
understood by
management
Corporate Governance Foreign countries Regulations and
regulations and institutions are well known
institutional practices are
uniquely different
Foreign Exchange Risk MNCs face it due to their No subsidiaries only risk is
subsidiaries as well as import/export of
export or import of competitors
competitors
Political Risk Huge because of their Negligible political risk
subsidiaries or high profile
Modifications of domestic MNCs use modified Limited used of derivatives
finance financial instruments like because of low forex and
options, forwards, futures political risk
etc.
 Free Trade
Q1.What is Free trade?
Q2. Does free trade applied to goods and
services only?
Q3. Does Free Trade benefit society?
 Free Trade
• Ans 1.
– You can trade without any frictions
– Borders are irrelevant: No tariffs or taxes
– Since, countries employ taxes to protect their businesses in
reality there are “freer” trade agreements instead of free trade
agreements
• Ans 2.
– It also applies to free trade of : land, labor and capital
– Land is not transferrable but ownership is
• Ans 3. It’s ambiguous because it depends upon how society
define benefit
– Example: if benefit means increasing standard of living of people
one way to measure it could be increases in wages
 Why Firms Pursue International
Business
• Theory of Comparative Advantage
• Imperfect Market Theory
• Product Cycle Theory
 Rise of International Company
• International Business activity is not new
• Transfer of goods and services across countries has been
taking place since thousands of years like spice routes
from Asia to Europe
• However, since World War II, international trade has
increased tremendously
• United nation estimated in 2012 that over 82,000 parent
companies around the world are MNCs
• One of the prominent theory for increased number of
MNCs is the doctrine of Comparative advantage
propounded by Adam Smith and David Ricardo
Example of Comparative Advantage Theory
• Suppose US and UK produce the same products wheat and
coal as per following schedule and units referred to are units
of production (labor, capital, land and technology)
Country Wheat Coal
U.K.
U.S. 2 units/ton 1 unit/ton
U.S.
U.K. 3 units/ton 4 units/ton

• Which country has absolute advantage?

• Which country has comparative advantage in which product?
 Contd..
• U.S. has absolute advantage in producing both
products and UK absolute disadvantage
• However, UK has comparative advantage in
producing wheat or it’s absolute disadvantage
is less in producing wheat which can be shown
as:
Country Wheat Coal
U.S. 0.5 tons/unit 1 ton/unit
U.K. 0.33 tons/unit 0.25 tons/unit

• Productivity of US relative to UK in coal is 4:1

(1/0.25)whereas it is only 1.5:1 (0.5/0.33) for
wheat
 Profitability before introduction of
trade
• To induce production of both wheat and coal
prior to introduction of trade, profitability of
producing both commodities must be identical
• This condition is satisfied only when return per
unit of production is same for both wheat and
coal in each country
• Hence, prior to introduction of trade between
two countries, exchange rate between wheat and
coal in US and UK must be:
• U.S. 1 ton wheat = 2 tons coal
• U.K. = 1 ton wheat = 0.75 tons coal
 Gains from Trade
• Thus, based on relative advantage there must be gains from trade to both
countries
• US can produce coal and exchange it with more quantity of wheat with UK than
within US
• UK can produce more of wheat and can exchange more of coal with US than within
• Hence, even if a country has absolute advantage in producing commodities, trade
is still possible among countries because of comparative advantage
• The gain for each country would depend upon the exchange rate between the two
countries following introduction of trade
• This exchange rate, known as terms of trade, depends upon relative supplies and
demands for wheat and coal in each country.
• However, any exchange rate between 0.75 and 2 tons of coal per ton on wheat will
lead to trade because at that rate both countries would improve their ability to
consume
• For example if terms of trade are 1:1 i.e. 1 ton of wheat equals 1 ton of coal
• By producing coal and trading for wheat, each production unit in US enables its
consumers to consume twice as much wheat as before
• Similarly, by producing wheat and exchanging it with coal, UK consumers are able
to consume 0.33 tons of coal 133% (0.33/0.25) more than before
 Specialized Factors of Production
• In producing and exchanging goods, normally factors of production
are specialized and can not be switched, those factors like those
producing coal (exported) in US will get more price
• Factors whose commodity is imported (wheat in U.S.) would see
their prices declining
• Reverse would be the case for UK
• Gain/loss to a factor would depend upon, magnitude of price shifts
after introduction of trade
• Suppose Trade terms are, 1 ton of wheat = 1.95 tons of coal
• Trade is still beneficial for both countries as it is between 0.75 and 2
tons
• UK gains enormously as each unit of wheat traded for coal would
provide 1.95 tons of coal, a 160% [(1.95/0.75)-1] increase relative to
earlier ratio
• US can now consume 2.5% more of wheat ((2-1.95)/2)
• Thus, there is a huge disparity of gains between the two countries
 Contd..
• Disparity among factors of production between two countries would be
different. For US factor growing wheat would be hurt
• If they continue growing wheat (as they can not switch because of
specialization), they would suffer an income loss of about 2.5% as each unit of
wheat would now would buy 2.5% less of coal i.e. 1.95 versus 2 tons earlier
• While factors growing coal would get 2.5% higher income
• The magnitude would be huge among factors in UK
• Factors producing wheat in UK would get 160% more coal now
• Coal miners would see their wheat purchasing power plummet from 1.33
(1/0.75) tons of wheat before trade to 0.5128 (1/1.95) tons of wheat now; a drop
of about 38% (0.5128/1.33) in wheat purchasing power
• This example illustrate a general principle in International Trade: The greater the
gains from trade for a country overall, the greater the cost of trade to those
factors of production that specialize in producing the commodity that is now
imported
• The less expensive imports put downward pressures on prices of domestic goods
and hence lower incomes in the hands of factors of production of domestic
goods
 Contd..
• This leads to the demands for protection
from imports
• However, this protection is a double-
edged sword?
 Protection of Trade: Double Edge Sword
• In 1980s the onslaught of Japanese cars in US markets
drove down price and quantity of cars sold by US
manufacturers reducing their profits
• Result was cheaper cars for US consumers but lower profit
for US car makers
• Thus, US manufacturers demanded protection against
Japanese car makers in form of quotas
• Japanese response against quotas was that they started
producing high quality cars with higher prices and profit
margins and shifted their production units to US
• As a result, US automakers had to improve their
manufacturing quality and invest in more capital & R&D
• So, quotas did not help US automakers much but only
slightly delayed the process of making improvements in
their manufacturing quality
• Consumers, however had to get costly cars because of
quotas
 Growth in MNCs
• During 1980s and 1990s fundamental political,
technology, regulatory and economic forces
radically changed the global competitive
environment:
– Massive Deregulations
– The collapse of communism
– Privatization of companies around the world
– Revolution in IT
– Waves of M&As, LBOs and takeovers
– Adoption of free market policies by emerging markets
 contd..
• Heightened competitiveness of international business
environment has compelled firms in Europe and
elsewhere to undergo process of restructuring to
remain competitive
• Rise of China has been the most dramatic change in
International Business which has attracted highest
amount of FDI and has become world’s second largest
economy in terms of GDP.
• Cheap labor has made China to be one of the largest
exporting country to world
• It has led to lot of companies around the world to set
up their manufacturing facilities in China
 Evolution of MNCs
• Various Considerations that prompted rise of MNCs are:
1. Search for raw material:
– British, French and Dutch firms established colonial rules based on it.
– Modern day counterparts are large oil and mining companies like British Petroleum
(BP) and Standard Oil, mineral companies like Anglo-American, Eramet and
Anaconda Copper to name a few
2. Market Seeking
– Either to sell unique products, processes and technologies or to increase economies
of scale
– Companies like IBM, Volkswagen, Unilever, Coca-Cola etc.
3. Cost Minimization
– Lower cost of production sites like Hong Kong, India, China, Vietnam etc.
4. Knowledge Seeking
– Some firms enter foreign markets to gain information and experience that is
expected to prove useful elsewhere like Japanese companies
5. Keeping Domestic Customers
– Following Volkswagen set up Brazilian production, many ancillary units set up their
businesses in Brazil to supply components
6. Exploiting Financial Market Imperfections
– Ability to reduce taxes , currency volatilities and reduce risk through
diversification
 Agency problem in MNC
• For example establishing subsidiary in a particular country may be manager’s
personal preference rather than it’s potential benefit to
shareholder
• Cost of Agency problem is high in MNC as compared to purely domestic firm
because:
– Monitoring managers in distant subsidiary is difficult
– Foreign subsidiary managers raised in different cultures may not follow uniform
rules
– Sheer size of large MNCs can create larger agency problems
– Subsidiary managers may pursue goals which may be good for subsidiary but may
not be good from MNC perspective
• Parent Control of Subsidiary:
– ESPOs
– Including Institutional Investors in Board
– Enactment of Sarbanes-Oxley Act 2002
 Management Structure of MNC
• Centralized
– Low agency cost due to better control of
subsidiaries
– Disadvantage is managers in parent company may
not be acquaint with all the countries where
subsidiaries are located and hence may take poor
decisions
• Decentralized
– High Agency Cost
– Better local decision making
 How Firms engage in International
Business
• International Trade
• Licensing
– IGA Inc. which operates more than 3000 supermarkets in U.S.A has licensing
agreement to operate supermarkets in China and Singapore
– Walt Disney is original owner of cartoons like Mickey Mouse, Donald duck etc.
But has given license to merchandisers to manufacture these products
• Franchising
– McDonald's, Pizza hut, Subway etc.
– It is mainly for services and ownership gets transferred unlike in licensing
which is mainly for products
• Joint Ventures
– Mahindra Renault, Bharti AXA
• Acquisition of Existing operations
– Google has done many acquisitions to expand it’s business in Russia, China,
Australia, Brazil
• Establishing New Foreign Subsidiaries
– Audi India, BMW India, HSBC Bank India
 Foreign Direct Investment (FDI)
• Method of increasing International business extends from simple
approach of international trade to more complex approach of
acquiring businesses
• Any method of increasing International business that requires a
direct investment in foreign operations is normally referred to as
Foreign Direct investment
• International trade and licensing usually are nor considered as FDI as
they do not involve direct investment in foreign operations
• Franchising and joint venture require limited amount of foreign
investment
• Foreign acquisitions and establishments of new foreign subsidiaries
require substantial investment in foreign operations and represent
large portion of FDI
• Many MNCs use combination of methods to increase international
trade
Cash Flow Diagrams for MNC
 Valuation Model for MNC:
International Cash Flows

[
E (CF$,t ) = å E (CF j ,t )´ E (S j ,t ) ]
m

j =1
§ where CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,

§ Sj,t represents the exchange rate at which the foreign currency

(measured in dollars per unit of the foreign currency) can be
converted to dollars at the end of period t.
 Uncertainty Surrounding MNC cash
Flows
1. Exposure to international economic
conditions
2. Exposure to international political risk
3. Exposure to exchange rate risk
Uncertainty of MNC Cost of Capital
• If there is uncertainty surrounding MNCs Cash
Flows it’s investors would seek higher returns
which would increase it’s cost of capital