Chapter

1
Multinational Financial Management:
An Overview

South-Western/Thomson Learning 2006

 Chapter Objectives

To identify the main goal of the multinational

corporation (MNC) and potential conflicts with that
goal;
To describe the key theories that justify
international business; and
To explain the common methods used to conduct
international business.

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 Multinational Corporations

MNCs are defined as firms that engage in some form

of international business.

Managers take Financial Management decisions that

are intended to maximize the value of MNC

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International Financial Management is important even
to companies that have no international business
because these companies must recognize how their
foreign competitors will be affected by movements in:
Exchange rates
Foreign Interest rates
Labor cost
Inflation

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 Goal of the MNC

The commonly accepted goal of an MNC is to

maximize shareholder wealth.
We will focus on MNCs that wholly own their
foreign subsidiaries.
Financial managers throughout the MNC
have a single goal of maximizing the value of the
entire MNC.

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 Conflicts with the MNC Goal
When a corporations shareholders differ from its
managers, a conflict of goals can existthe agency
problem.
Agency costs are normally larger for MNCs than for
purely domestic firms, due to:
the difficulty in monitoring distant managers,
the different cultures of foreign managers,
the sheer size of the larger MNCs, and
the tendency to downplay short-term effects.

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 Conflicts with the MNC Goal

Subsidiary managers may be tempted to make

decisions that maximize the values of their respective
subsidiaries.

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 Parent Control of Agency Problem
Proper governance
MNC should clearly communicate the goals for each
subsidiary to ensure that all subsidiaries focus on
maximizing the value of the MNC rather than their
respective subsidiary values
Satisfying the MNCs goals
Implementation of compensation plans (Stock
options, Annual bonus based on subsidiary earnings)

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 Corporate Control of Agency Problem
Goals of entire management of the MNC are not
focused on maximizing shareholders wealth.
Acquiring of MNC at low price and to remove the
weak management, hostile takeover threat
Influence of large stakeholders (Mutual funds or
Pension Funds), investor monitoring

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 SOX Sarbanes Oxley Act 2002
A transparent process for managers to report on the
productivity and financial condition of the firm
Establishing Internal reporting system
Establishing centralized database of information
Ensuring all data are reported consistently among
subsidiaries
Implementing a system that automatically checks data
for any discrepancies
Speeding of access of data to all departments or
subsidiaries
Accountability of executives

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 Management Structure of an MNC

The magnitude of agency costs can vary with the

management style of the MNC.
A centralized management style reduces agency
costs. However, a decentralized style gives more
control to those managers who are closer to the
subsidiarys operations and environment.

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 Management Structure of an MNC

Decentralized management style may be more

effective to the extent that subsidiary managers
recognize the goal of maximizing the value of overall
MNC and are compensated in accordance with that
goal.

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Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Cash

Management Managers Management
at A of Parent at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
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Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Financial Cash

Management Managers Managers Management
at A of A of B at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
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 Impact of Management Control
Some MNCs attempt to strike a balance they
allow subsidiary managers to make the key
decisions for their respective operations, but the
parents management monitors the decisions.
Today, electronic networks make it easier for the
parent to monitor the actions and performance of
its foreign subsidiaries.

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 Constraints Interfering with the
MNCs Goal
MNC managers are confronted with various
constraints:
environmental constraints
regulatory constraints
ethical constraints

A recent study found that investors assigned a

higher value to firms that exhibit high corporate
governance standards and are likely to obey ethical
constraints.

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Theories of International Business

Why are firms motivated to expand

their business internationally?
Theory of Comparative Advantage
Specialization by countries can increase production
efficiency.
When a country specializes in some products, it may not
produce other products so trade between countries is
essential (Argument made by Classical theory of
Comparative advantage)
Comparative advantage allow firms to penetrate foreign
markets

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Theories of International Business
Imperfect Markets Theory
If the markets are perfect, FOPs were easily
transferable wherever they in demand but in
reality the markets for the various resources
used in production are imperfect.
The unrestricted mobility of factors would create
equality in costs and returns and remove the
comparative cost advantage, the rationale of
International trade and business whereas in
reality FOP are somewhat immobile.

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Theories of International Business
Imperfect Markets Theory

There are cost and other restrictions related to

transfer of FOPs among countries
Imperfect markets provide an incentive for firms
to seek out foreign opportunities

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Theories of International Business
Product Cycle Theory
As a firm matures, it may recognize additional opportunities
outside its home country.
Production of goods in foreign markets (Reduction in
transportation cost)
Whether the firms foreign business diminishes or expands
over time will depend on how successful it is maintaining
some advantage over its competition

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 The International Product Life Cycle

Firm creates Firm exports

product to product to Firm
accommodate accommodate establishes
local demand foreign demand foreign
subsidiary
to establish
presence in
a. Firm or foreign
differentiates b. Firms country
product from foreign and
competitors business possibly to
and/or expands declines as its reduce
product line in competitive costs
foreign country advantages are
eliminated
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 International
Business Methods
International trade involves exporting
and/or importing.
Minimal risk approach because firm does not place
any of its capital at risk.
If the firm experiences a decline in its exporting or
importing, it can normally reduce or discontinue this
part of business at a low cost.
Internet Facilitation

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 International
Business Methods
Licensing allows a firm to provide its
technology in exchange for fees or some other
benefits. (Copyrights, patents, trademarks)
Allows firms to use their technology in foreign
markets without a major investment in foreign
countries and in transportation cost
Major disadvantage of licensing for the firm
providing the technology to ensure quality control in
foreign production process.

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 International
Business Methods
Franchising obligates a firm to provide a
specialized sales or service strategy, support
assistance, and possibly an initial investment,
in exchange for periodic fees.
Franchising also allows a firm to penetrate without
a major investment in foreign market

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 International
Business Methods
Firms may also penetrate foreign markets by
engaging in a joint venture (joint ownership and
operation) with firms that reside in those
markets.
Most joint ventures allow two firms to apply their
respective comparative advantages in a given
project.

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 International
Business Methods
Acquisitions of existing operations in foreign
countries allow firms to quickly gain control
over foreign operations as well as a share of
the foreign market.
Acquisitions of an existing operations is subject to
the risk of large loses because of large
investments.
Partial International Acquisitions

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 International
Business Methods
Firms can also penetrate foreign markets
by establishing new foreign subsidiaries.
Establishing new subsidiaries may be preferred
to foreign acquisitions because the operations
can be tailored exactly to firms needs.

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 International
Business Methods
Many MNCs use a combination of methods to
increase international business.
In general, any method of conducting business that
requires a direct investment in foreign operations is
referred to as a direct foreign investment (DFI).

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 International
Business Methods
International trade and Licensing usually are not considered to
be DFI because they do not involve direct investment I foreign
operations
Franchising and Joint ventures tend to require some investment
in foreign operations but to a limited degree
Foreign acquisitions and establishment of new foreign
subsidiaries require substantial investment in foreign operations
and represent largest portion of DFI

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 Cash Flows for MNCs
International Trade by the MNC
Cash inflows from Exporting

Foreign Importers

MNC Cash outflows to pay for Importing

Foreign Exporters

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 Cash Flows for MNCs
Licensing, Franchising, Joint Venture by the MNC

Cash inflows from Service provided

Foreign firms or
Govt Agencies
MNC Cash outflows for services received

Cash outflow may be the cost associated to comply with the

arrangement such as expenses incurred from transferring
technology or funding partial investment in a franchise or joint
venture

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 Cash Flows for MNCs
Investment in Foreign Subsidiary by the MNC

Cash inflows from Remitted Earnings

Foreign
Subsidiaries
MNC Cash outflows to finance the operations

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 Valuation Model for an MNC
Domestic Model
n
E CF$, t
Value =
t =1 1 k t

E (CF$,t ) = expected cash

flows to be received at the end of
period t
n = the number of periods into
the future in which cash flows are
received
k = the required rate of return
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 Valuation Model for an MNC
Domestic Model
A firms decisions about how it should invest funds to
expand its business can effect its expected future
cash flows and therefore can effect the firms value
Holding other factors constant, an increase in
expected cash flows over time should increase the
value of the firm

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 Valuation Model for an MNC
Domestic Model
If the firms credit rating suddenly lowered, the cost of
capital will probably increase.
Holding other factors constant, an increase in the
firms required rate of return will reduce the value of
the firm because expected cash flows must be
discounted at a higher interest rate
A decrease in the firms required rate of return will
increase the value of the firm because expected cash
flows are discounted at a lower required rate of return

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 Valuation Model for an MNC
Valuing International Cash Flows

E CF E ER
m

j, t j, t
n

Value = j 1

t =1 1 k t


E (CFj,t ) = expected cash flows
denominated in currency j to be received by the
U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
the end of period t
k = the weighted average cost of capital
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 Valuation Model for an MNC
Valuation of an MNC that uses two Currencies

MNC that does business in two currencies could

measure its expected cash flow in any period by
multiplying the expected cash flow in each currency
times the expected exchange rate at which that
currency could be converted to dollars and summing
two products.

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 Valuation Model for an MNC
Valuation of an MNC that uses two Currencies

Example:
Carolina Co. has expected cash flows of $100,000
from local business and 1 million Mexican pesos
from business in Mexico at the end of period t.
Assuming that the pesos value is expected to be
$.09 when converted into dollars.
Calculate the expected dollar cash flows?

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 Valuation Model for an MNC
Valuation of an MNC that uses:

-Multiple Currencies
-Cash flows over Multiple Periods

E CF E ER
m

j, t j, t
n

Value = j 1

t =1 1 k t

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 Valuation Model for an MNC
Valuation of an MNC that uses:
-Cash flows over Multiple Periods
Value of the MNC will increase in response to managerial
decisions that increase the amount of its cash flows in a
particular currency or to conditions that increase the
exchange rate at which that currency is converted into
dollars
Any expected cash flows received by foreign subsidiaries
should not be counted in the valuation until they are
expected to be remitted to the parent

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 Valuation Model for an MNC
Valuation of an MNC that uses:
-Cash flows over Multiple Periods
Weighted average cost of capital for the MNC is based
on funding some projects that reflect business in
different countries
Any decision affecting cost of capital will cause low
value of MNC

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 Uncertainty surrounding an MNC
cash flow
International business usually increases
an MNCs exposure to:
International Economic Conditions

Political Conditions
Exchange Rate Risk

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Uncertainty surrounding an MNC
cash flow
International Economic Conditions
If economic conditions weakens, the income of
consumers become relatively low and affect on
consumption.
Consumer purchase of products decline----
MNC sales lower---- Lower MNC cash flows----
Reduction in Value

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Uncertainty surrounding an MNC
cash flow
Political Conditions
Foreign Govt may increase taxes or impose
barriers on the subsidiary
Consumers in foreign market may boycott the
MNC if there is a friction between the foreign
Govt and MNC

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Uncertainty surrounding an MNC
cash flow
Exchange Rate Risk

Foreign currency to be received by a US

based MNC suddenly weakens against the
dollar, MNC will receive a lower amount of
dollar cash flows (From exports
perspective, Income received)

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Uncertainty surrounding an MNC
cash flow
Exchange Rate Risk
If foreign currency strengthen, the MNC will
need a larger amount of dollars to obtain the
foreign currencies to make payments and
reduces the MNC cash flows and its value
(From Imports perspective, payments)

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Uncertainty of an MNC Cost of
Capital
Higher level of uncertainty increases the
return on investment required by the
investors which reflects an increase in the
MNC cost of obtaining capital and MNC
valuation decreases.

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Impact of Financial Management and
International Conditions on Value
An MNC will decide how much business to conduct in
each country and how much financing to obtain in
each currency.
The MNCs financial decisions determine its exposure
to the international environment.
An MNC can control its degree of exposure
to exchange rate effects, economic conditions, and
political conditions with its financial management.

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