TRADE FINANCE

(BBEC 306)
Presentation 1: An Overview of The
Multinational Financial Environment

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 Lesson Objective
• Identify the main goal of the MNC and
conflicts with that goal.

• Describe the key theories that justify

international business, and

• Explain the common methods used to conduct

international business

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 What Are Multinational Companies
(MNC’s)?
• MNCs are firms that engage in some form of
international business.

• Their goal is to maximize shareholder wealth.

• Within MNCs, is the Principal/agency relationship.

• The principal sets the goals and monitors the

actions of the agent who carries out the tasks.
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 Conflicts of an MNC’s Goal:

• Agents/managers may have the moral hazard to pursue either

their personal or the subsidiary’s goal at the expense of the
overall goal.

– The ‘goals’ of agents include perquisite consumption such as high

expenses and substituting leisure for work.

• This conflict of interest is the Agency problem.

• The agency problem results in agency costs.

– Agency Costs are costs of ensuring that managers maximise shareholder
wealth

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 Agency Costs of MNCs vs. Domestic
Companies
• Agency costs of MNCs are usually larger
because:

1. Difficulty in monitoring subsidiaries.

2. Foreign managers in different cultures maybe
influenced by these different cultures.
3. The sheer size of the larger MNC can also create
communication problems.
4. The complexity in the operations of the MNC

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 The Agency Problem Solutions
• To counteract the moral hazard of managers, use:
– Bonus schemes

– Rules and regulations including internal and external auditing.

– Monitoring to reduce information asymmetry by using independent auditors, and regulations

i.e., adopting proper accounting standards.

– Impact of management control i.e., centralized vs.. Decentralized management style.

– Internet facilities and software.

– external influences such as hostile takeover threats, and investor monitoring by individuals,
pressure groups, and institutions (investment trusts, pension funds, and insurance companies).
• Institutional investors monitor via the financial press, annual and interim reports, and investor briefings.

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 Types of Management Styles
• These are
1. Centralized
2. Decentralized

• Centralised Management Style allows managers of

the parent to control foreign subsidiaries and
therefore reduce the power of subsidiary managers.
– Disadvantage- parent company may make a poor decision
for the subsidiary if not well informed about the financial
characteristics of the subsidiary.

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 Types of Management Styles
• Decentralised management style gives more control
to managers who are closer to the subsidiary’s
operations and environment.

– Disadvantage- results in higher agency costs because

subsidiary managers may make decisions that do not
focus on maximising the value of the entire MNC.

• Class question: which management style do you

prefer and why?
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Constraints Interfering With an MNCs Goal
1. Environmental constraints:
– these include constraints on
• building codes
• disposal of production waste
• and pollution controls

2. Regulatory constraints:
– these constraints are in the areas of:
• taxes
• currency convertibility rules
• earnings remittance restrictions

3. Ethical constraints:
– There is no worldwide consensus on the standard of conducting business.
– The equator principle helps to solve the absolute/relative standards problem.

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 Theories of International Business
Firms expand internationally because of:

Economic related theories

Business related theories

Economic related theories include:

(1) The theory of absolute advantage by Adam Smith
(2)The theory of comparative advantage by David Ricardo

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 Economic Theories
• The theory of comparative advantage: The world needs international trade
because:
– Some countries have specialised in the production of some products.

– Their specialisation leads to an increase in production efficiency.

– Specialisation in some products means no production of some other equally needed

goods.

• The Heckscher-Ohlin Theorem: The world needs international trade because:

– The resources for production are more abundant in some countries than others.

– Such countries should therefore specialise in the production of some goods in order
to gain a comparative advantage.

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 Economic Theories Cont’d
Theory of Absolute Advantage: it assumes a
two-world economy.
– This world needs international trade because:
• A country may produce some goods more efficiently
than others.
• Countries should concentrate on such goods and
produce them in excess of their needs.
• The country should then trade its excess production
with the other country.

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 Economic Theories cont’d
• Imperfect Market Theory:
– The world needs international trade because:
• Countries differ with respect to resources available for
production.
• Imperfect market provides an incentive for firms to
seek out foreign opportunities

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 Business Theories
• Product cycles theory: refer to Doc1.docx

• Global Strategies: here, international business

is seen as a product of global strategies being
pursued by MNCs like Swiss Rolex watches.

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 International Business Methods
1. International trade
2. Licensing
3. Franchising
4. Joint ventures
5. Acquisition of existing operations
6. Establishing new foreign subsidiaries

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 International Trade
• It is a conservative way of penetrating a
foreign market.
• It occurs by exporting or by importing.
• Minimal risk is involved.

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 Licensing
• A firm can penetrate a foreign market by issuing a license to a foreign
firm to use its technology i.e.,
– Copyrights
– Patents
– Trademarks
– Trade names.

• Advantage:
– No major investment is made in the foreign country,
– Transportation costs involved in exporting are avoided.

• Disadvantage:
• Controlling for quality in the foreign production process is difficult.

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 Franchising
• A firm can penetrate a foreign market by providing the
following in a franchise agreement:
• specialised sales or service strategy
• support assistance
• an initial investment
– They are provided in the franchise in exchange for periodic
fees.

• Advantage:
– The local firm gains access to new markets without major
investment.

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 Joint Ventures
• A firm can penetrate a foreign market through
a venture that is jointly owned and operated
by two or more firms.
– The local firm engages in a joint venture with firms
that reside in those markets.

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 Acquisitions
• A firm can penetrate a foreign market by acquiring another firm.

Advantages:
• Allows firms to quickly take over full control over foreign businesses
• The firm quickly obtains a large portion of the foreign market share.

Disadvantages:
• Riskier because it requires large investments.
• it is difficult to sell operations at a reasonable price if foreign
operations perform poorly.

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 Establishing New Foreign Subsidiaries
• A firm can penetrate a foreign market by establishing new
operations in foreign countries.

Advantages:
• Can be tailored exactly to the firm’s needs.
• The investment amount may be less when compared to an
acquisition.

Disadvantages:
• Requires a large amount of investment.
• Rewards are not immediate.

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 Direct Foreign Investment (DFI)
• Some international business methods require
direct investment in foreign operations. This
helps international business.
– Such investments are called direct foreign
investment (DFI).

• Class question:
– Which of the methods discussed so far in this
lesson qualifies as a DFI?

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Global Trends & Trade
 Opportunities in Europe
These include:
1. The Single European act of 1987.
– uniform regulations on goods
– removal of taxes on goods

2. The removal of the Berlin Wall.

3. The single currency, the Euro.

– Single currency means single monetary policy
• MNC’s can focus on just one monetary policy
– Reduction in concerns about exchange rate fluctuations

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 Opportunities in Latin America
• Trade barriers were eliminated between the
United States and Mexico.
– This happened in The North American Free Trade
Agreement (NAFTA).
• It was signed in 1993.
Advantages:
• Access to other product and labour markets.

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 Opportunities in Asia
• The Asian crisis of 1997-1998 caused many local companies to
go bankrupt.

• The values of local firms were reduced.

• This created an opportunity for foreign firms to easily acquire

them.

• Interest rates went up

• Borrowing rate reduced.

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 International Business and Risk
• MNCs reduce their exposure to their home
country’s economic conditions.

• MNCs however increase their exposure to:

– Exchange rate movements
– Foreign economic conditions
– Political risk increases.

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1. Exposure To Exchange Rate Movements

• Exchange rate fluctuates over time.

• Exchange rate fluctuations affect the number of units of a

firm’s home currency needed to purchase foreign supplies.

• Exchange rate fluctuations can affect foreign demand for a

firm’s product.

• Therefore, the value of cash flows remitted to the parent

company would be affected.

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2. Exposure to Foreign Economies
• Economic conditions in a foreign market affect
the demand for an MNC’s product.

– E.g., the Asian crisis in 1997-1998, adversely

affected gambling in Mirage Resorts (Asia).

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 3. Exposure To Political Risk
• MNCs are exposed to political risk.

• Political risk: political actions taken by the host government

or the public that affect the MNC’s cash flow.

– E.g., of political actions:

– Host government may impose higher taxes on subsidiaries in
retaliation for actions by the home country’s government.

– Host government can decide to buy out the subsidiary at

whatever price it decides is fair

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 Host Country MNC Relationships
• MNCs need to keep good relationships with many
countries.

• They may lose their focus on their goal by pursuing

other goals such as a natural resource-seeking goal.

• The relationship between a country and an MNC is

therefore not simple in that there are positives and
negatives.

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 MNC Valuation
• There are three distinct ways of valuing a company:

• Stock market valuation by finding the market

capitalization of the company

• Valuation in the Accounts by finding the book value of

the company.

• Financial academic models: by using the discounted cash

flow model.

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 Assignment:
1. Briefly write an example of a company that has gone international via
each of the following international business methods:
– International trade
– Licensing
– Franchising
– Joint ventures
– Acquisition of existing operation
– New foreign subsidiaries

2. Reading: Valuation of MNCs

– Study the differences in the cash flow of MNCs with the following profiles:
MNCs focused on international trade, MNCs focused on international trade
and international arrangements.

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