The International Financial

Environment: Multinational
Financial Management
Department of Islamic Economics
Universitas Airlangga

Reference: Chapter 1, International Financial Management 13th

Edition by Jeff Madura (2018)
Learning Part I:
The International Financial Environment
Chapter 1
Multinational Financial
Management
Chapter Objectives

• To identify the main goal of the

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

• Multinational corporations
(MNCs) are defined as firms that
engage in some form of
international business.
• The goal of is to maximize their
firm’s value, which is the same goal
pursued by managers employed by
strictly domestic companies
• The commonly accepted goal of an
MNC is to maximize shareholder
wealth.
How Business Disciplines Are Used to Manage the MNC

• Various business disciplines are integrated to

manage the MNC in a manner that maximizes
shareholder wealth
• Finance is used to make investment and
financing decisions for the MNC. Common
finance decisions include:
• whether to discontinue operations in a particular
country,
• whether to pursue new business in a particular
country,
• whether to expand business in a particular country,
and
• how to finance expansion in a particular country
Conflicts Against the MNC Goal

• For corporations with shareholders who

differ from their managers, a conflict of
goals can exist - the agency problem.
• Agency costs are normally larger for
MNCs than for purely domestic firms,
influenced by:
• The sheer size of the MNC.
• The scattering of distant subsidiaries.
• The culture of foreign managers.
• Subsidiary value versus overall MNC value.
Management Structure of an MNC (1)
Management Structure of an MNC (2)
Impact of Management Control

• The magnitude of agency costs can vary

with the management style of the MNC.
• A centralized management style reduces
agency costs. However, a decentralized
style gives more control to those managers
who are closer to the subsidiary’s
operations and environment.
Impact of Management Control (Cont.)

• Some MNCs attempt to strike a balance -

they allow subsidiary managers to make the
key decisions for their respective operations,
but the decisions are monitored by the
parent’s management
• Electronic networks make it easier for the
parent to monitor the actions and
performance of foreign subsidiaries.
• For example, corporate intranet or internet
email facilitates communication. Financial
reports and other documents can be sent
electronically too.
Impact of Management Control (Cont.)

• Various forms of corporate control can

reduce agency costs.
• Stock compensation for board members
and executives.
• The threat of a hostile takeover.
• Monitoring and intervention by large
shareholders.
Theories of International Business

• Theory of Comparative Advantage

• Specialization by countries can increase production
efficiency.
• Imperfect Markets Theory
• The markets for the various resources used in production
are “imperfect.”
• Product Cycle Theory
• As a firm matures, it may recognize additional opportunities
outside its home country.
The International Product Life Cycle
Methods to Conduct International Business

• International trade is a relatively conservative approach

involving exporting and/or importing.
• The internet facilitates international trade by enabling firms to advertise
and manage orders through their websites.
• Licensing allows a firm to provide its technology in exchange
for fees or some other benefits.
• Franchising obligates a firm to provide a specialized sales or
service strategy, support assistance, and possibly an initial
investment in the franchise in exchange for periodic fees.
Methods to Conduct International Business (Cont.)

• Joint venture. Firms may also penetrate foreign

markets by engaging in a joint venture (joint
ownership and operation) with firms that reside in
those markets.
• Acquisitions of existing operations in foreign
countries allow firms to quickly gain control over
foreign operations as well as a share of the foreign
market.
Methods to Conduct International Business (Cont.)

• Firms can also penetrate foreign markets by

establishing new foreign subsidiaries.
• In general, any method of conducting business that
requires a direct investment in foreign operations is
referred to as a direct foreign investment (DFI).
• The optimal international business method may
depend on the characteristics of the MNC.
Cash Flow Diagrams for MNCs
Valuation Model for an MNC

• The value of an MNC is relevant to its shareholders and its

debt holders
• When managers make decisions that maximize the firm’s value,
they also maximize shareholder wealth (assuming that the
decisions are not intended to maximize the wealth of debt
holders at the expense of shareholders)
• There are numerous methods of valuing an MNC, some
ofwhich lead to the same valuation.
• The method described in this section reflects the keyfactors
affecting an MNC’s value in a general sense.
Valuation Model 1: Domestic Model

E (CF$,t ) = expected cash flows to be

received at the end of period t
n = the number of periods into the future in
which cash flows are received
k = the required rate of return by investors
Valuation Model 2: Multinational Model (Two Currencies)

E (CFj,t)= expected cash flows denominated in currency

j to be received by the company parent at the end of
period t
E (Sj,t ) = expected exchange rate at which currency j
can be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S.
parent company
Valuation Model 2: Multinational Model (Multiple Currencies and
Periods)

E (CFj,t)= expected cash flows denominated in currency

j to be received by the company parent at the end of
period t
E (Sj,t ) = expected exchange rate at which currency j
can be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S.
parent company
Valuation Model for an MNC

• An MNC’s financial decisions include how much

business to conduct in each country and how much
financing to obtain in each currency.
• Its financial decisions determine its exposure to the
international environment.
 Valuation Model for an MNC (Cont.)
• How an MNC’s Valuation Is Exposed to Uncertainty (Risk)
 Example (Valuation of an MNC That Uses Two
Currencies)
• 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 peso’s value is
expected to be $.09 when converted into dollars, the expected dollar cash flows are:

CF = Cash flow
Sj,t denotes the exchange rate
 Example (Valuation of an MNC Multiple
Periods)
• Austin Co. is a U.S.-based MNC that sells video games to U.S. consumers; it also has European subsidiaries that
produce and sell the games in Europe. The firm’s European earnings are denominated in euros (the currency of
most European countries), and these earnings are typically remitted to the U.S. parent. Last year, Austin received
$40 million in cash flows from its U.S. operations and 20 million euros from its Euro_x0002_pean operations.
The euro was valued at $1.30 when remitted to the U.S parent, so Austin’s cash flows last year are calculated as
follows:

• Assume that Austin Co. plans to continue its business in the United States and Europe for the next three years. As a
basic valuation model, the firm could use last year’s cash flows to estimate each future year’s cash flows; then its
expected cash flows would be $66 million for each of the next three years. Its valuation could be estimated by
discounting these cash flows at its cost of capital
 Chapter Review

• Goal of the MNC

• Conflicts Against the MNC Goal
• Impact of Management Control
• Impact of Corporate Control
• Constraints Interfering with the MNC’s Goal
• Theories of International Business
• Theory of Comparative Advantage
• Imperfect Markets Theory
• Product Cycle Theory
 Chapter Review

• International Business Methods

• International Trade
• Licensing
• Franchising
• Joint Ventures
• Acquisitions of Existing Operations
• Establishing New Foreign Subsidiaries
 Chapter Review

• Valuation Model for an MNC

• Domestic Model
• Valuing International Cash Flows
• Impact of Financial Management and International Conditions on
Value
Any Question?