PART 1

The International Financial

Environment

Part 1 (Chapters 1 through 5) provides an overview of the multinational

corporation (MNC) and the environment in which it operates. Chapter 1 explains
the goals of the MNC, along with the motives and risks of international business.
Chapter 2 describes the international flow of funds between countries. Chapter 3
describes the international financial markets and how these markets facilitate
ongoing operations. Chapter 4 explains how exchange rates are determined, and
Chapter 5 provides background on the currency futures and options markets.
Managers of MNCs must understand the international environment described
in these chapters in order to make proper decisions.

Multinational
Corporation (MNC)

Foreign Exchange Markets

Dividend
Remittance
and
Financing
Exporting and Importing Investing and Financing

International
Product Markets Subsidiaries Financial Markets

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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 1
Multinational Financial
Management: An Overview

CHAPTER Multinational corporations (MNCs) are defined as firms that engage in

OBJECTIVES some form of international business. Their managers conduct international
The specific financial management, which involves international investing and
objectives of this financing decisions that are intended to maximize the value of the MNC.
chapter are to:
The goal of these managers is to maximize their firm’s value, which is
■ identify the the same goal pursued by managers employed by strictly domestic
management goal
and organizational
companies.
structure of the Initially, firms may merely attempt to export products to a certain country
MNC, or import supplies from a foreign manufacturer. Over time, however, many of
■ describe the key these firms recognize additional foreign opportunities and eventually
theories that justify
international
establish subsidiaries in foreign countries. Dow Chemical, IBM, Nike, and
business, many other firms have more than half of their assets in foreign countries.
■ explain the
Some businesses, such as ExxonMobil, Fortune Brands, and Colgate-
common methods Palmolive, commonly generate more than half of their sales in foreign
used to conduct countries. It is typical also for smaller U.S. firms to generate more than
international
business, and 20 percent of their sales in foreign markets; examples include Ferro (Ohio)
■ provide a model for
and Medtronic (Minnesota). Seventy-five percent of U.S. firms that export
valuing the MNC. have fewer than 100 employees.
International financial management is important even to companies
that have no international business. The reason is that these companies
must recognize how their foreign competitors will be influenced
by movements in exchange rates, foreign interest rates, labor costs,
and inflation. Such economic characteristics can affect the foreign
competitors’ costs of production and pricing policies.
This chapter provides background on the goals, motives, and valuation of
a multinational corporation.

1-1 MANAGING THE MNC

The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers em-
ployed by the MNC are expected to make decisions that will maximize the stock price and
thereby serve the shareholders’ interests. Some publicly traded MNCs based outside the
United States may have additional goals, such as satisfying their respective governments,
3

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4 Part 1: The International Financial Environment

creditors, or employees. However, these MNCs now place greater emphasis on satisfying
shareholders; that way, the firm can more easily obtain funds from them to support its opera-
tions. Even in developing countries (e.g., Bulgaria and Vietnam) that have just recently
encouraged the development of business enterprise, managers of firms must serve share-
holder interests in order to secure their funding. There would be little demand for the stock
of a firm that announced the proceeds would be used to overpay managers or invest in
unprofitable projects.
The focus of this text is on MNCs whose parents wholly own any foreign subsidiaries,
which means that the U.S. parent is the sole owner of the subsidiaries. This is the most
common form of ownership of U.S.-based MNCs, and it gives financial managers
throughout the firm the single goal of maximizing the entire MNC’s value (rather than
the value of any particular subsidiary). The concepts in this text apply generally also to
MNCs based in countries other than the United States.

1-1a How Business Disciplines Are Used to Manage the MNC

Various business disciplines are integrated to manage the MNC in a manner that max-
imizes shareholder wealth. Management is used to develop strategies that will motivate
and guide employees who work in an MNC and to organize resources so that they can
efficiently produce products or services. Marketing is used to increase consumer aware-
ness about the products and to monitor changes in consumer preferences. Accounting
and information systems are used to record financial information about revenue and
expenses of the MNC, which can be used to report financial information to investors
and to evaluate the outcomes of various strategies implemented by the MNC. 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.
These finance decisions for each MNC are partially influenced by the other business
discipline functions. The decision to pursue new business in a particular country is based
on comparing the costs and potential benefits of expansion. The potential benefits of
such new business depend on expected consumer interest in the products to be sold
(marketing function) and expected cost of the resources needed to pursue the new busi-
ness (management function). Financial managers rely on financial data provided by the
accounting and information systems functions.

1-1b Agency Problems

Managers of an MNC may make decisions that conflict with the firm’s goal of maximiz-
ing shareholder wealth. For example, a decision to establish a subsidiary in one location
versus another may be based on the location’s appeal to a particular manager rather than
on its potential benefits to shareholders. A decision to expand a subsidiary may be moti-
vated by a manager’s desire to receive more compensation rather than to enhance the
value of the MNC. This conflict of goals between a firm’s managers and shareholders is
often referred to as the agency problem.
The costs of ensuring that managers maximize shareholder wealth (referred to as
agency costs) are normally larger for MNCs than for purely domestic firms for several
reasons. First, MNCs with subsidiaries scattered around the world may experience larger

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 Chapter 1: Multinational Financial Management: An Overview 5

agency problems because monitoring the managers of distant subsidiaries in foreign

countries is more difficult. Second, foreign subsidiary managers who are raised in
different cultures may not follow uniform goals. Third, the sheer size of the larger
MNCs can also create significant agency problems. Fourth, some non-U.S. managers
tend to downplay the short-term effects of decisions, which may result in decisions for
foreign subsidiaries of the U.S.-based MNCs that maximize subsidiary values or pursue
other goals. This can be a challenge, especially in countries where some people may per-
ceive that the first priority of corporations should be to serve their respective employees.
EXAMPLE Two years ago, Seattle Co. (based in the United States) established a subsidiary in Singapore so
that it could expand its business there. It hired a manager in Singapore to manage the subsidiary.
During the last two years, the sales generated by the subsidiary have not grown. Even so, the
manager hired several employees to do the work that he was assigned. The managers of the par-
ent company in the United States have not closely monitored the subsidiary because it is so far
away and because they trusted the manager there. Now they realize that there is an agency prob-
lem. The subsidiary is experiencing losses every quarter, so its management must be more closely
monitored. l

Parent Control of Agency Problems The parent corporation of an MNC may

be able to prevent most agency problems with proper governance. The parent should
clearly communicate the goals for each subsidiary to ensure that all of them focus on
maximizing the value of the MNC and not of their respective subsidiaries. The parent
can oversee subsidiary decisions to check whether each subsidiary’s managers are satisfy-
ing the MNC’s goals. The parent can also implement compensation plans that reward
those managers who satisfy the MNC’s goals. A common incentive is to provide man-
agers with the MNC’s stock (or options to buy that stock at a fixed price) as part of their
compensation; thus the subsidiary managers benefit directly from a higher stock price
when they make decisions that enhance the MNC’s value.
EXAMPLE When Seattle Co. (from the previous example) recognized the agency problems with its Singapore
subsidiary, it created incentives for the manager of the subsidiary that were aligned with the par-
ent’s goal of maximizing shareholder wealth. Specifically, it set up a compensation system whereby
the manager’s annual bonus is based on the subsidiary’s earnings. l

Corporate Control of Agency Problems In the example of Seattle Co., the

agency problems occurred because the subsidiary’s management goals were not focused
on maximizing shareholder wealth. In some cases, agency problems can occur because
the goals of the entire management of the MNC are not focused on maximizing
shareholder wealth. Various forms of corporate control can help prevent these agency
problems and thus induce managers to make decisions that satisfy the MNC’s share-
holders. If these managers make poor decisions that reduce the MNC’s value, then an-
other firm might acquire it at the lower price and hence would probably remove the
weak managers. Moreover, institutional investors (e.g., mutual and pension funds) with
large holdings of an MNC’s stock have some influence over management because they
will complain to the board of directors if managers are making poor decisions. Institu-
tional investors may seek to enact changes, including removal of high-level managers or
even board members, in a poorly performing MNC. Such investors may also band to-
gether to demand changes in an MNC, since they know that the firm would not want
to lose all of its major shareholders.

How SOX Improved Corporate Governance of MNCs One limitation of the

corporate control process is that investors rely on reports by the firm’s own managers for
information. If managers are serving themselves rather than the investors, they may

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6 Part 1: The International Financial Environment

exaggerate their performance. There are many well-known examples (such as Enron and
WorldCom) in which large MNCs were able to alter their financial reporting and hide
problems from investors.
Enacted in 2002, the Sarbanes-Oxley Act (SOX) ensures a more transparent process
for managers to report on the productivity and financial condition of their firm. It
requires firms to implement an internal reporting process that can be easily monitored
by executives and the board of directors. Some of the common methods used by MNCs
to improve their internal control process are:
■ establishing a centralized database of information,
■ ensuring that all data are reported consistently among subsidiaries,
■ implementing a system that automatically checks data for unusual discrepancies
relative to norms,
■ speeding the process by which all departments and subsidiaries access needed
data, and
■ making executives more accountable for financial statements by personally verifying
their accuracy.
These systems made it easier for a firm’s board members to monitor the financial
reporting process. In this way, SOX reduced the likelihood that managers of a firm can
manipulate the reporting process and therefore improved the accuracy of financial infor-
mation for existing and prospective investors.

1-1c Management Structure of an MNC

The magnitude of agency costs can vary with the MNC’s management style. A central-
ized management style, as illustrated in the top section of Exhibit 1.1, can reduce agency
costs because it allows managers of the parent to control foreign subsidiaries and thus
reduces the power of subsidiary managers. However, the parent’s managers may make
poor decisions for the subsidiary if they are less informed than the subsidiary’s managers
about its setting and financial characteristics.
Alternatively, an MNC can use a decentralized management style, as illustrated in the
bottom section of Exhibit 1.1. This style is more likely to result in higher agency costs
because subsidiary managers may make decisions that fail to maximize the value of the
entire MNC. Yet this management style gives more control to those managers who are
closer to the subsidiary’s operations and environment. To the extent that subsidiary
managers recognize the goal of maximizing the value of the overall MNC and are
compensated in accordance with that goal, the decentralized management style may be
more effective.
Given the clear trade-offs between centralized and decentralized management
styles, some MNCs attempt to achieve the advantages of both. That is, they allow
subsidiary managers to make the key decisions about their respective operations while
the parent’s management monitors those decisions to ensure they are in the MNC’s
best interests.
How the Internet Facilitates Management Control The Internet is making it
easier for the parent to monitor the actions and performance of its foreign subsidiaries.
EXAMPLE Recall the example of Seattle Co., which has a subsidiary in Singapore. The Internet allows the
foreign subsidiary to e-mail updated information in a standardized format that reduces language
problems and also to send images of financial reports and product designs. The parent can then
easily track the inventory, sales, expenses, and earnings of each subsidiary on a weekly or
monthly basis. Thus, using the Internet can reduce agency costs due to international aspects of
an MNC’s business. l

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 Chapter 1: Multinational Financial Management: An Overview 7

Exhibit 1.1 Management Styles of MNCs

Centralized Multinational
Financial Management

Cash Management Financial Managers Cash Management

at Subsidiary A of Parent at Subsidiary B

Inventory and Inventory and

Accounts Receivable Accounts Receivable
Management at Management at
Subsidiary A Subsidiary B

Capital Capital
Financing at Financing at
Expenditures Expenditures
Subsidiary A Subsidiary B
at Subsidiary A at Subsidiary B

Decentralized Multinational
Financial Management

Cash Management Financial Managers Financial Managers Cash Management

at Subsidiary A of Subsidiary A of Subsidiary B at Subsidiary B

Inventory and Inventory and

Accounts Receivable Accounts Receivable
Management at Management at
Subsidiary A Subsidiary B

Capital Capital
Financing at Financing at
Expenditures Expenditures
Subsidiary A Subsidiary B
at Subsidiary A at Subsidiary B

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8 Part 1: The International Financial Environment

1-2 WHY FIRMS PURSUE INTERNATIONAL BUSINESS

Three commonly held theories to explain why firms become motivated to expand their
business internationally are (1) the theory of comparative advantage, (2) the imperfect
markets theory, and (3) the product cycle theory. These theories overlap to some extent
and can complement each other in developing a rationale for the evolution of interna-
tional business.

1-2a Theory of Comparative Advantage

Multinational business has generally increased over time. Part of this growth is due to
firms’ increased realization that specialization by countries can increase production
efficiency. Some countries, such as Japan and the United States, have a technology advan-
tage whereas others, such as China and Malaysia, have an advantage in the cost of basic
labor. Because these advantages cannot be easily transported, countries tend to use their
advantages to specialize in the production of goods that can be produced with relative effi-
ciency. This explains why countries such as Japan and the United States are large producers
of computer components while countries such as Jamaica and Mexico are large producers
of agricultural and handmade goods. Multinational corporations like Oracle, Intel, and IBM
have grown substantially in foreign countries because of their technology advantage.
A country that specializes in some products may not produce other products, so trade be-
tween countries is essential. This is the argument made by the classical theory of comparative
advantage. Comparative advantages allow firms to penetrate foreign markets. Many of the
Virgin Islands, for example, specialize in tourism and rely completely on international trade
for most products. Although these islands could produce some goods, it is more efficient for
them to specialize in tourism. That is, the islands are better-off using some revenues earned
from tourism to import products than attempting to produce all the products they need.

1-2b Imperfect Markets Theory

If each country’s markets were closed to all other countries, then there would be no interna-
tional business. At the other extreme, if markets were perfect and so the factors of produc-
tion (such as labor) were easily transferable, then labor and other resources would flow
wherever they were in demand. Such unrestricted mobility of factors would create equality
in both costs and returns and thus would remove the comparative cost advantage, which is
the rationale for international trade and investment. However, the real world suffers from
imperfect market conditions where factors of production are somewhat immobile. There
are costs and often restrictions related to the transfer of labor and other resources used for
production. There may also be restrictions on transferring funds and other resources among
countries. Because markets for the various resources used in production are “imperfect,”
MNCs such as the Gap and Nike often capitalize on a foreign country’s particular resources.
Imperfect markets provide an incentive for firms to seek out foreign opportunities.

1-2c Product Cycle Theory

One of the more popular explanations as to why firms evolve into MNCs is the product
cycle theory. According to this theory, firms become established in the home market as a
result of some perceived advantage over existing competitors, such as a need by the mar-
ket for at least one more supplier of the product. Because information about markets and
competition is more readily available at home, a firm is likely to establish itself first in its
home country. Foreign demand for the firm’s product will initially be accommodated by
exporting. As time passes, the firm may feel the only way to retain its advantage over

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 Chapter 1: Multinational Financial Management: An Overview 9

competition in foreign countries is to produce the product in foreign markets, thereby

reducing its transportation costs. The competition in those foreign markets may increase
as other producers become more familiar with the firm’s product. The firm may develop
strategies to prolong the foreign demand for its product. One frequently used approach
is to differentiate the product so that competitors cannot duplicate it exactly. These
phases of the product cycle are illustrated in Exhibit 1.2. For instance, 3M Co. uses one
new product to enter a foreign market, after which it expands the product line there.
There is, of course, more to the product cycle theory than summarized here. This
discussion merely suggests that, as a firm matures, it may recognize additional opportu-
nities outside its home country. Whether the firm’s foreign business diminishes or
expands over time will depend on how successful it is at maintaining some advantage
over its competition. That advantage could be an edge in its production or financing
approach that reduces costs or an edge in its marketing approach that generates and
maintains a strong demand for its product.

1-3 HOW FIRMS ENGAGE IN INTERNATIONAL BUSINESS

Firms use several methods to conduct international business. The most common
methods are:
■ international trade,
■ licensing,
■ franchising,

Exhibit 1.2 International Product Life Cycle

1 2
Firm creates product to Firm exports product to
accommodate local accommodate foreign
demand. demand.

4a
Firm differentiates product
from competitors and/or
expands product line in
foreign country. 3
Firm establishes foreign
or subsidiary to establish
presence in foreign
country and possibly
4b to reduce costs.
Firm’s foreign business
declines as its competitive
advantages are eliminated.

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10 Part 1: The International Financial Environment

■ joint ventures,
■ acquisitions of existing operations, and
■ establishment of new foreign subsidiaries.
Each method will be discussed in turn, with particular attention paid to the respective
risk and return characteristics.

1-3a International Trade

International trade is a relatively conservative approach that can be used by firms to
penetrate markets (by exporting) or to obtain supplies at a low cost (by importing).
WEB
This approach entails minimal risk because the firm does not place any of its capital at
www.trade.gov/mas/ian risk. If the firm experiences a decline in its exporting or importing, it can normally
Outlook of international reduce or discontinue that part of its business at a low cost.
trade conditions for Many large U.S.-based MNCs, including Boeing, DuPont, General Electric, and IBM,
each of several generate more than $4 billion in annual sales from exporting. Nonetheless, small
industries. businesses account for more than 20 percent of the value of all U.S. exports.
How the Internet Facilitates International Trade Many firms use their
websites to list the products they sell along with the price for each product. This makes
it easy for them to advertise their products to potential importers anywhere in the
world without mailing brochures to various countries. Furthermore, a firm can add to
its product line or change prices simply by revising its website. Thus, importers need
only check an exporter’s website periodically in order to keep abreast of its product
information.
Firms can also use their websites to accept orders online. Some products, such as
software, can be delivered directly to the importer over the Internet in the form of a
file on the importer’s computer. Other products must be shipped, but even in that
case the Internet makes it easier to track the shipping process. An importer can trans-
mit its order for products via e-mail to the exporter, and when the warehouse ships the
products it can send an e-mail message to the importer and to the exporter’s headquar-
ters. The warehouse may also use technology to monitor its inventory of products so
that suppliers are automatically notified to send more supplies once the inventory falls
below a specified level. If the exporter has multiple warehouses, the Internet allows
them to operate as a network; hence if one warehouse cannot fill an order, another
warehouse will.

1-3b Licensing
Licensing is an arrangement whereby one firm provides its technology (copyrights,
patents, trademarks, or trade names) in exchange for fees or other considerations.
Starbucks has licensing agreements with SSP (an operator of food and beverage
concessions in Europe) to sell Starbucks products in train stations and airports
throughout Europe. Sprint Nextel Corp. has a licensing agreement to develop tele-
communications services in the United Kingdom. Eli Lilly & Co. has a licensing
agreement to produce drugs for foreign countries, and IGA, Inc., which operates
more than 1,700 supermarkets in the United States, has a licensing agreement to
operate markets in China and Singapore. Licensing allows firms to use their technol-
ogy in foreign markets without a major investment in foreign countries and without
the transportation costs that result from exporting. A major disadvantage of licensing
is that it is difficult for the firm providing the technology to ensure quality control in
the foreign production process.

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 Chapter 1: Multinational Financial Management: An Overview 11

1-3c Franchising
Under a franchising arrangement, one firm provides a specialized sales or service strat-
egy, support assistance, and possibly an initial investment in the franchise in exchange
for periodic fees. For example, McDonald’s, Pizza Hut, Subway Sandwiches, Blockbuster,
and Dairy Queen have franchises that are owned and managed by local residents in
many foreign countries. As in the case of licensing, franchising allows firms to penetrate
foreign markets without a major investment in foreign countries. The recent relaxation
of barriers in countries throughout Eastern Europe and South America has resulted in
numerous franchising arrangements.

1-3d Joint Ventures

A joint venture is a venture that is jointly owned and operated by two or more firms.
Many firms enter foreign markets by engaging in a joint venture with firms that already
reside in those markets. Most joint ventures allow two firms to apply their respective
comparative advantages in a given project. For instance, General Mills, Inc., joined in a
venture with Nestlé SA so that the cereals produced by General Mills could be sold
through the overseas sales distribution network established by Nestlé.
Xerox Corp. and Fuji Co. (of Japan) engaged in a joint venture that allowed Xerox to
penetrate the Japanese market while allowing Fuji to enter the photocopying business.
Sara Lee Corp. and AT&T have engaged in joint ventures with Mexican firms to gain
entry to Mexico’s markets. Joint ventures between automobile manufacturers are numer-
ous, since each manufacturer can offer its own technological advantages. General Motors
has ongoing joint ventures with automobile manufacturers in several different countries,
including the former Soviet states.

1-3e Acquisitions of Existing Operations

Firms frequently acquire other firms in foreign countries as a means of penetrating for-
eign markets. Such acquisitions give firms full control over their foreign businesses and
enable the MNC to quickly obtain a large portion of foreign market share.
EXAMPLE Google, Inc., has made major international acquisitions to expand its business and improve its
technology. It has acquired businesses in Australia (search engines), Brazil (search engines),
Canada (mobile browser), China (search engines), Finland (micro-blogging), Germany (mobile
software), Russia (online advertising), South Korea (weblog software), Spain (photo sharing), and
Sweden (videoconferencing). l

However, the acquisition of an existing corporation could lead to large losses because
of the large investment required. In addition, if the foreign operations perform poorly
then it may be difficult to sell the operations at a reasonable price.
Some firms engage in partial international acquisitions in order to obtain a toehold
or stake in foreign operations. This approach requires a smaller investment than that of
a full international acquisition and so exposes the firm to less risk. On the other hand,
the firm will not have complete control over foreign operations that are only partially
acquired.

1-3f Establishment of New Foreign Subsidiaries

Firms can also penetrate foreign markets by establishing new operations in foreign coun-
tries to produce and sell their products. Like a foreign acquisition, this method requires a
large investment. Establishing new subsidiaries may be preferred to foreign acquisitions

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12 Part 1: The International Financial Environment

because the operations can be tailored exactly to the firm’s needs. In addition, a smaller
investment may be required than would be needed to purchase existing operations.
However, the firm will not reap any rewards from the investment until the subsidiary is
built and a customer base established.

1-3g Summary of Methods

The methods of increasing international business extend from the relatively simple
approach of international trade to the more complex approach of acquiring foreign firms
or establishing new subsidiaries. Any method of increasing international business that
requires a direct investment in foreign operations normally is referred to as a direct for-
eign investment (DFI). International trade and licensing are usually not viewed as
examples of DFI because they do not involve direct investment in foreign operations.
Franchising and joint ventures tend to require some investment in foreign operations
but only to a limited degree. Foreign acquisitions and the establishment of new foreign
subsidiaries require substantial investment in foreign operations and account for the
largest portion of DFI.
Many MNCs use a combination of methods to increase international business. For
example, IBM and PepsiCo engage in substantial direct foreign investment yet also de-
rive some of their foreign revenue from various licensing agreements, which require less
DFI to generate revenue.
EXAMPLE The evolution of Nike began in 1962 when Phil Knight, a student at Stanford’s business school,
wrote a paper on how a U.S. firm could use Japanese technology to break the German dominance
of the athletic shoe industry in the United States. After graduation, Knight visited the Unitsuka
Tiger shoe company in Japan. He made a licensing agreement with that company to produce a shoe
that he sold in the United States under the name Blue Ribbon Sports (BRS). In 1972, Knight exported
his shoes to Canada. In 1974, he expanded his operations into Australia. In 1977, the firm licensed
factories in Taiwan and Korea to produce athletic shoes and then sold the shoes in Asian countries.
In 1978, BRS became Nike, Inc., and began to export shoes to Europe and South America. As a result
of its exporting and its direct foreign investment, Nike’s international sales reached $1 billion by
1992 and now exceed $8 billion per year. l

The effects of international business on an MNC’s cash flows is illustrated in Exhibit 1.3.
In general, the cash outflows associated with international business by the U.S. par-
ent are used to pay for imports, to comply with its international arrangements, and/
or to support the creation or expansion of foreign subsidiaries. At the same time, an
MNC receives cash flows in the form of payment for its exports, fees for the services
it provides within international arrangements, and remitted funds from the foreign
subsidiaries. The first diagram in this exhibit illustrates the case of an MNC that
engages in international trade; its international cash flows therefore result either
from paying for imported supplies or from receiving payment in exchange for pro-
ducts that it exports.
The second diagram illustrates an MNC that engages in some international arrange-
ments (which could include international licensing, franchising, or joint ventures). Any
such arrangement may require cash outflows of the MNC in foreign countries to cover,
for example, the expenses associated with transferring technology or funding partial
investment in a franchise or joint venture. These arrangements generate cash flows
for the MNC in the form of fees for services (e.g., technology, support assistance) that
it provides.
The third diagram in Exhibit 1.3 illustrates the case of an MNC that engages in direct
foreign investment. This type of MNC has one or more foreign subsidiaries. There can
be cash outflows from the U.S. parent to its foreign subsidiaries in the form of invested

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 Chapter 1: Multinational Financial Management: An Overview 13

Exhibit 1.3 Cash Flow Diagrams for MNCs

International Trade by the MNC

Cash Inflows from Exporting

Foreign Importers
MNC
Cash Outflows to Pay for Importing
Foreign Exporters

Licensing, Franchising, Joint Ventures by the MNC

Cash Inflows from Services Provided

Foreign Firms or
MNC Government
Cash Outflows for Services Received
Agencies

Investment in Foreign Subsidiaries by the MNC

Cash Inflows from Remitted Earnings

Foreign
MNC
Cash Outflows to Finance the Operations Subsidiaries

funds to help finance the operations of the foreign subsidiaries. There are also cash flows
from the foreign subsidiaries to the U.S. parent in the form of remitted earnings and fees
for services provided by the parent; all of these flows can be classified as remitted funds
from the foreign subsidiaries.

1-4 VALUATION MODEL FOR AN MNC

The value of an MNC is relevant to its shareholders and its debt holders. When man-
agers 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). Given that international financial management
should be conducted with the goal of increasing the MNC’s value, it is useful to review
some basics of valuation. There are numerous methods of valuing an MNC, some of
which lead to the same valuation. The method described in this section reflects the key
factors affecting an MNC’s value in a general sense.

1-4a Domestic Model

Before modeling an MNC’s value, consider the valuation of a purely domestic firm
that does not engage in any foreign transactions. The value (V) of a purely domestic

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14 Part 1: The International Financial Environment

firm in the United States is commonly specified as the present value of its expected
cash flows:
( )
X
n
E ðCF$,t Þ
V ¼
t ¼1 ð1 þ kÞt
Here E(CF$,t) denotes expected cash flows to be received at the end of period t; n is the
number of future periods in which cash flows are received; and k represents not only the
weighted average cost of capital but also the required rate of return by investors and
creditors who provide funds to the MNC.
Dollar Cash Flows The dollar cash flows in period t represent funds received by
the firm minus funds needed to pay expenses or taxes or to reinvest in the firm (such
as an investment to replace old computers or machinery). The expected cash flows are
estimated from knowledge about various existing projects as well as other projects that
will be implemented in the future. A firm’s decisions about how it should invest funds
to expand its business can affect its expected future cash flows and therefore can affect
the firm’s value. Holding other factors constant, an increase in expected cash flows over
time should increase the value of a firm.
Cost of Capital The required rate of return (k) in the denominator of the valua-
tion equation represents the cost of capital (including both the cost of debt and the
cost of equity) to the firm and is, in essence, a weighted average of the cost of capital
based on all of the firm’s projects. In making decisions that affect its cost of debt or
equity for one or more projects, the firm also affects the weighted average of its cost
of capital and thus the required rate of return. If the firm’s credit rating is suddenly
lowered, for example, then its cost of capital will probably increase and so will its re-
quired rate of return. Holding other factors constant, an increase in the firm’s required
rate of return will reduce the value of the firm because expected cash flows must be
discounted at a higher interest rate. Conversely, a decrease in the firm’s required rate
of return will increase the value of the firm because expected cash flows are discounted
at a lower required rate of return.

1-4b Multinational Model

An MNC’s value can be specified in the same manner as a purely domestic firm’s value.
However, consider that the expected cash flows generated by a U.S.-based MNC’s parent
in period t may be coming from various countries and so may be denominated in differ-
ent foreign currencies.
The foreign currency cash flows will be converted into dollars. Thus, the expected
dollar cash flows to be received at the end of period t are equal to the sum of the
products of cash flows denominated in each currency j multiplied by the expected
exchange rate at which currency j could be converted into dollars by the MNC at the
end of period t:
X
m
E ðCF$,t Þ ¼ ½E ðCFj ,t Þ  E ðS j ,t Þ
j¼1

Here CFj,t represents the amount of cash flow denominated in a particular foreign cur-
rency j at the end of period t, and Sj,t denotes 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.

Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 Chapter 1: Multinational Financial Management: An Overview 15

Valuation of an MNC That Uses Two Currencies An MNC that does busi-
ness in two currencies could measure its expected dollar cash flows in any period by
multiplying the expected cash flow in each currency by the expected exchange rate at
which that currency could be converted to dollars and then summing those two
products.
It may help to think of an MNC as a portfolio of currency cash flows, one for each
currency in which it conducts business. The expected dollar cash flows derived from
each of those currencies can be combined to determine the total expected dollar cash
flows in the given period. It is easier to derive an expected dollar cash flow value for
each currency before combining the cash flows among currencies within a given period,
because each currency’s cash flow amount must be converted to a common unit (the
dollar) before combining the amounts.
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 peso’s value is expected to be $.09
when converted into dollars, the expected dollar cash flows are:
X
m
E ðCF$,t Þ ¼ ½E ðCFj ,t Þ  E ðS j ,t Þ
j¼1
¼ ð$100,000Þ þ ½1,000,000 pesos  ð$:09Þ
¼ ð$100,000Þ þ ð$90,000Þ
¼ $190,000:

The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars and therefore
did not have to be converted. l

Valuation of an MNC That Uses Multiple Currencies The same process as

just described can be employed to value an MNC that uses many foreign currencies. The
general formula for estimating the dollar cash flows to be received by an MNC from
multiple currencies in one period can be written as follows:
X
m
E ðCF$,t Þ ¼ ½E ðCFj ,t Þ  E ðS j ,t Þ
j¼1

EXAMPLE Assume that Yale Co. will receive cash in 15 different countries at the end of the next period. To
estimate the value of Yale Co., the first step is to estimate the amount of cash flows that it will
receive at the end of the period in each currency (such as 2 million euros, 8 million Mexican pesos,
etc.). Second, obtain a forecast of the currency’s exchange rate for cash flows that will arrive at
the end of the period for each of the 15 currencies (such as euro forecast ¼ $1.40, peso forecast ¼
$.12, etc.). The existing exchange rate can be used as a forecast for the future exchange rate, but
there are many alternative methods (as explained in Chapter 9). Third, multiply the amount of each
foreign currency to be received by the forecasted exchange rate of that currency in order to esti-
mate the dollar cash flows to be received due to each currency. Fourth, add the estimated dollar
cash flows for all 15 currencies in order to determine the total expected dollar cash flows in the pe-
riod. The previous equation captures the four steps just described. When applying that equation to
this example, m ¼ 15 because there are 15 different currencies. l

Valuation of an MNC’s Cash Flows over Multiple Periods The entire pro-
cess described in the example for a single period is not adequate for valuation because most
MNCs have multiperiod cash flows. However, the process can be easily adapted to estimate
the total dollar cash flows for all future periods. First, apply the same process described for a
single period to all future periods in which the MNC will receive cash flows; this will gener-
ate an estimate of total dollar cash flows to be received in every period in the future. Second,
discount the estimated total dollar cash flow for each period at the weighted cost of capital
(k) and then sum these discounted cash flows to estimate the value of this MNC.

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16 Part 1: The International Financial Environment

The process for valuing an MNC receiving multiple currencies over multiple periods
can be expressed formally as:
8 m 9
> X >
>
> ½E ðCFj ,t Þ  E ðS j ,t Þ>
>
X
n >
< >
=
j¼1
V ¼
t ¼1
>
>
> ð1 þ kÞt >
>
>
>
: >
;

Here CFj,t is the cash flow denominated in a particular currency (which may be dollars)
and Sj,t denotes represents the exchange rate at which the MNC can convert the foreign
to the domestic currency at the end of period t. Whereas the previous equation is applied
to single-period cash flows, this equation considers cash flows over multiple periods and
then discounts those flows to obtain a present value.
Since the management of an MNC should be focused on maximizing its value, the
equation for valuing an MNC is extremely important. According to this equation, the
value (V) will increase in response to managerial decisions that increase the amount of
its cash flows in a particular currency (CFj) or to conditions that increase the exchange
rate at which that currency is converted into dollars (Sj).
To avoid double counting, cash flows of the MNC’s subsidiaries are considered in the
valuation model only when they reflect transactions with the U.S. parent. Therefore, any
expected cash flows received by foreign subsidiaries should not be counted in the valua-
tion equation unless they are expected to be remitted to the parent.
The denominator of the valuation model for the MNC remains unchanged from the
original valuation model for the purely domestic firm. However, note that the weighted
average cost of capital for the MNC is based on funding some projects involving business
in different countries. Hence any decision by the MNC’s parent that affects the cost of its
capital supporting projects in a specific country will also affect its weighted average cost
of capital (and required rate of return) and thereby its value.
EXAMPLE Austin Co. is a U.S.-based MNC that sells electronic games to U.S. consumers; it also has European
subsidiaries that produce and sell the games in Europe. The firm’s European earnings are denomi-
nated 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 European 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.
Austin’s total
$ cash flowslast year ¼ $ cash flows from U:S: operations þ $ cash flows from foreign operations
¼ $ cash flows from U:S: operations þ ½ðeuro cash flowsÞ  ðeuro exchange rateÞ
¼ $40,000,000 þ ½ð20,000,000 eurosÞ  ð$1:30Þ
¼ $40,000,000 þ $26,000,000
¼ $66,000,000

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 fu-
ture 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. l

1-4c Uncertainty Surrounding an MNC’s Cash Flows

The MNC’s future cash flows (and therefore its valuation) are subject to uncertainty
because of its exposure not only to domestic economic conditions but also to interna-
tional economic conditions, political conditions, and exchange rate risk. These factors
are explained next, and Exhibit 1.4 complements the discussion.

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 Chapter 1: Multinational Financial Management: An Overview 17

Exhibit 1.4 How an MNC’s Valuation Is Exposed to Uncertainty (Risk)

Uncertain foreign currency cash flows

due to uncertain foreign economic Uncertainty surrounding
and political conditions future exchange rates

n ^ [E (CFj,t ) 3 E (Sj,t )]
V5^
j51

t51 (1 1 k )t

Uncertainty Surrounding an MNC’s Valuation:

Exposure to Foreign Economies: If [CFj,t , E (CFj,t )] V

Exposure to Political Risk: If [CFj,t , E (CFj,t )] V
Exposure to Exchange Rate Risk: If [Sj,t , E (Sj,t )] V

Exposure to International Economic Conditions To the extent that a foreign

country’s economic conditions affect an MNC’s cash flows, they affect the MNC’s valua-
tion. The cash inflows that an MNC receives from sales in a foreign country during a
given period depends on the demand by that country’s consumers for the MNC’s pro-
ducts, which in turn is affected by that country’s national income in that period. If eco-
nomic conditions improve in that country, consumers there may enjoy an increase in
their income and the employment rate may rise. In that case, those consumers will
have more money to spend and their demand for the MNC’s products will increase.
This illustrates how the MNC’s cash flows increasing because of its exposure to interna-
tional economic conditions.
However, an MNC can also be adversely affected by its exposure to international eco-
nomic conditions. If conditions weaken in the foreign country where the MNC does
business, that country’s consumers suffer a decrease in their income and the employment
rate may decline. Then those consumers have less money to spend, and their demand for
the MNC’s products will decrease. In this case, the MNC’s cash flows are reduced
because of its exposure to international economic conditions.
When Facebook went public in 2012, the registration statement acknowledged its
exposure to international economic conditions: “We plan to continue expanding our
operations abroad where we have limited operating experience and may be subject to
increasing business and economic risks that could affect our financial results.”
International economic conditions can also affect the MNC’s cash flows indirectly by
affecting the MNC’s home economy. Consider that when a country’s economy strength-
ens and hence its consumers buy more products from firms in other countries, the firms
in those other countries experience stronger sales and cash flows. Therefore, the owners
and employees of these firms have more income. When they spend a portion of that
higher income locally, they stimulate their local economy.

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18 Part 1: The International Financial Environment

Conversely, if the foreign country’s economy weakens and hence its consumers buy
fewer products from firms in other countries, then the firms in those countries experi-
ence weaker sales and cash flows. The owners and employees of these firms therefore
have less income, and if they reduce spending locally their local economy weakens.
There is much international trade between the United States and Europe. European
countries under weak economic conditions tend to reduce their demand for U.S.-made
products. The result may be weaker economic conditions in the United States, which
may lead to lower national income and higher unemployment there. Then U.S. consu-
mers would have less money to spend and so would reduce their demand for the pro-
ducts offered by U.S.-based MNCs. In recent years, the financial press has featured
extensive coverage on how bad economic conditions in European countries adversely
affect the U.S economy. Similarly, research has documented that U.S. stock market per-
formance is highly sensitive to economic conditions in Europe.
The effects on international economic conditions are illustrated in Exhibit 1.5,
which shows how weak European conditions can affect the valuations of U.S.-based
MNCs. The top string of effects (from left to right) in this exhibit indicate how weak
European economic conditions cause a decline in the demand for the products made
by U.S. firms. The result is weaker cash flows of the U.S.-based MNCs that sell pro-
ducts either as exports or through their European subsidiaries to European customers.
However, there is an additional adverse effect of the weak European economy on
U.S.-based MNCs and even on domestic U.S. firms. As the U.S.-based MNCs experi-
ence weaker cash flows, they may reduce their workforce or the number of hours that
employees work. Furthermore, the profits earned by their owners are reduced. Thus
not only the employees but also the owners of U.S.-based MNCs have less money to

Exhibit 1.5 Potential Effects of International Economic Conditions

Reduced
European
Demand for
Products at
European
Subsidiaries
of U.S. Firms Reduced
Reduced
Sales and
Weak European Valuations
Cash Flows
Economy of U.S.
of U.S.
Firms
Firms
Reduced
European
Demand
for U.S.
Firms’
Exports Weak
Weak U.S. Demand
U.S. for Products
Economy at U.S.
Firms

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 Chapter 1: Multinational Financial Management: An Overview 19

spend, so all U.S. firms will likewise experience reduced sales and cash flows. This
means that a weak European economy, in addition to reducing European demand for
the products of U.S.-based MNCs, also weakens the U.S. economy and thus reduces
U.S. demand for those products.
EXAMPLE Recall from the original example for Austin Co. that it has expected annual cash flows of $40 million
from its U.S. operations. If Europe experiences a recession, however, then Austin expects reduced
European demand for many U.S. products, and this will adversely affect the U.S. economy. Under these
conditions, the U.S. demand for Austin’s computer games would decline, reducing its expected annual
cash flows due to U.S. operations from $40 million to $38 million. A European recession would naturally
result also in reduced European demand for Austin’s computer games, so the company reduces its
expected euro cash flows due to European operations from 20 million euros to 16 million euros. l

Exposure to International Political Risk Political risk in any country can affect
the level of an MNC’s sales. A foreign government may increase taxes or impose barriers
on the MNC’s subsidiary. Alternatively, consumers in a foreign country may boycott the
MNC if there is friction between the government of their country and the MNC’s home
country. Political actions like these can reduce the cash flows of an MNC. The term “coun-
try risk” is commonly used to reflect an MNC’s exposure to a variety of country condi-
tions, including political actions such as friction within the government, government
policies (such as tax rules), and financial conditions within that country.
Exposure to Exchange Rate Risk If the foreign currencies to be received by a
U.S.-based MNC suddenly weaken against the dollar, then the MNC will receive a lower
amount of dollar cash flows than expected. Therefore, the MNC’s cash flows will be reduced.
EXAMPLE Recall from the previous example that Austin Co. now anticipates a European recession and so has
revised its expected annual cash flows to be 16 million euros from its European operations. The
dollar cash flows that Austin will receive from these euro cash flows depend on the exchange rate
at the time those euros are converted to dollars. If the exchange rate is expected to be $1.30,
then Austin’s cash flows are predicted as follows.
Austin’s $ cash flows resulting
from European operations ¼ Austin’s cash flows in euros  euro exchange rate
¼ 16,000,000 euros  $1:30
¼ $20,800,000

However, if Austin believes that the anticipated European recession will cause the euro’s value to
weaken and be worth only $1.20 when the euros are converted into dollars, then its estimate of
the dollar cash flows from European operations would be revised as follows.
Austin’s $ cash flows resulting
from European operations ¼ Austin’s cash flows in euros  euro exchange rate
¼ 16,000,000 euros  $1:20
¼ $19,200,000

Thus, Austin’s expected dollar cash flows are reduced as a result of reducing the expected value of
the euro at the time of conversion into dollars.
This conceptual framework can be used to understand how MNCs such as Facebook or Google are
affected by exchange rate movements. Google now receives more than half of its total revenue
from outside the United States as it provides advertising for non-U.S. companies targeted at
non-U.S. users. Consequently, Google’s dollar cash flows are favorably affected when the currencies
it receives appreciate against the dollar over time.
As Facebook attracts more users in Europe, it will attract more demand for advertising by Euro-
pean firms and therefore will receive more cash flows in euros. As it sells more ads to firms in other
countries, it will receive more cash flows in their respective currencies. Its international revenue as
a percentage of total revenue has consistently increased over the last four years and it is now

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20 Part 1: The International Financial Environment

approaching 50 percent. As Facebook’s international business continues to grow, its estimated dol-
lar cash flows in any period will necessarily become more sensitive to the exchange rates of these
currencies relative to the dollar. If the revenue it receives is denominated in currencies that
appreciate against the dollar over time, then its dollar cash flows and valuation will increase.
Conversely, if the revenue it receives is denominated in currencies that depreciate against the
dollar over time, its dollar cash flows and valuation will decrease. l

Many MNCs have cash outflows in one or more foreign currencies because they
import supplies or materials from companies in other countries. When an MNC antici-
pates future cash outflows in foreign currencies, it is exposed to exchange rate move-
ments but in the opposite direction. If those foreign currencies strengthen, then the
MNC will require more dollars to obtain the foreign currencies needed to make its
payments. This dynamic reduces the MNC’s dollar cash flows (on a net basis) overall
and so diminishes its value.

1-4d Summary of International Effects

Exhibit 1.4 summarized how an MNC’s expected cash flows and valuation are subject to
uncertainty through exposure to international conditions. Up to this point, the possible
impact of each international condition on an MNC’s cash flows has been treated in
isolation. In reality, however, an MNC must consider the impact of all international con-
ditions so that it can determine the resulting effect on its cash flows.
EXAMPLE Recall the original example of Austin Co., a U.S.-based MNC that expects to generate $40 million
annually in cash flows from its operations in the United States and 20 million euros annually in cash
flows from its operations in Europe over the next three years. Assume that Austin anticipates a
possible European recession during this period and therefore revises its expectations as follows to
reflect that possibility.

1. The company expects that a European recession will adversely affect the U.S. economy and
result in reduced U.S. demand for its computer games; it therefore reduces its estimated
dollar cash flows from U.S. operations to $38 million annually over the next three years.
2. Austin expects that a European recession will result in a reduced European demand for its
computer games, so it lowers its estimated euro cash flows from European operations to
16 million euros annually over the next three years.
3. The firm expects that a European recession will weaken the euro and hence lowers its estimate
of the euro’s value to $1.20 over the next three years. Altogether, then, Austin’s expected
annual cash flows for each of the next three years are now calculated as follows.
Austin’s total expected $ cash
flows each year ¼ $ cash flows from U:S: operations þ $ cash flows from foreign operations
¼ $ cash flows from U:S: operations þ ½ðeuro cash flowsÞ  ðeuro exchange rateÞ
¼ $38,000,000 þ ½ð16,000,000 eurosÞ  ð$1:20Þ
¼ $38,000,000 þ $19,200,000
¼ $57,200,000 l
Comparing these estimates to those in the original example reveals how each of the
three revisions in expectations affects expected cash flows. The expected dollar cash flows
from U.S. operations are reduced. The expected euro cash flows are reduced and the ex-
pected exchange rate is lower; both of these factors reduce the estimate of dollar cash
flows from foreign operations. The expected annual dollar cash flows for Austin in the
original example were $66 million, whereas the revised expectation is only $57.2 million.
This example clearly illustrates just how adversely an MNC’s cash flows can be affected
by exposure to international conditions.

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 Chapter 1: Multinational Financial Management: An Overview 21

1-4e How Uncertainty Affects the MNC’s Cost of Capital

If there is suddenly more uncertainty about an MNC’s future cash flows, then investors
will expect to receive a higher rate of return. Thus more uncertainty increases the return
on investment required by investors (and thus the MNC’s cost of obtaining capital),
which lowers the firm’s valuation.
EXAMPLE Since Austin Co. does substantial business in Europe, its value is strongly influenced by how much
revenue it expects to earn from that business. As a result of some events that occurred in Europe
today, economic conditions in Europe are subject to considerable uncertainty. Although Austin does
not change its forecasts of expected cash flows, it is concerned that the actual flows could deviate
substantially from those forecasts. The increased uncertainty surrounding these cash flows has
increased the firm’s cost of capital, because its investors now require a higher rate of return. In
other words, the numerator (estimated cash flows) of the valuation equation has not changed but
the denominator has increased owing to the increased uncertainty surrounding the cash flows.
Thus, the valuation of Austin Co. has decreased. l

In some periods, the uncertainty surrounding conditions that influence cash flows of
MNCs could decline. In that case, the uncertainty surrounding cash flows also declines
and results in a lower required rate of return and cost of capital for MNCs. Conse-
quently, the valuations of MNCs increase.

1-5 ORGANIZATION OF THE TEXT

The chapters in this textbook are organized as shown in Exhibit 1.6. Chapters 2 through 8
discuss international markets and conditions from a macroeconomic perspective, focusing

Exhibit 1.6 Organization of Chapters

Exchange Rate Exchange Rate

Behavior Risk Management
(Chapters 6–8) (Chapters 9–12)

Background Long-Term
on International Investment and Risk and Return Value and Stock
Financial Markets Financing Decisions of MNC Price of MNC
(Chapters 2–5) (Chapters 13–18)

Short-Term
Investment and
Financing Decisions
(Chapters 19–21)

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22 Part 1: The International Financial Environment

on external forces that can affect the value of an MNC. Although financial managers can-
not control such forces, they can control the extent of their firm’s exposure to them. These
macroeconomically oriented chapters provide the background necessary to make financial
decisions.
Chapters 9 through 21 take a microeconomic perspective and focus on how the finan-
cial management of an MNC can affect its value. Financial decisions by MNCs are com-
monly classified as either investing decisions or financing decisions. In general, investing
decisions by an MNC tend to affect the numerator of the valuation model because such
decisions affect expected cash flows. In addition, investing decisions by the MNC that
alter the firm’s weighted average cost of capital may also affect the denominator of the
valuation model. Long-term financing decisions by an MNC tend to affect the denomi-
nator of the valuation model because they affect its cost of capital.

SUMMARY
■ The main goal of an MNC is to maximize share- commonly expand their product specialization
holder wealth. When managers are tempted to in foreign countries.
serve their own interests instead of those of share- ■ The most common methods by which firms con-
holders, an agency problem exists. Multinational duct international business are international trade,
corporations tend to experience greater agency licensing, franchising, joint ventures, acquisitions
problems than do domestic firms because man- of foreign firms, and formation of foreign
agers of foreign subsidiaries might be tempted to subsidiaries. Methods such as licensing and fran-
make decisions that serve their subsidiaries instead chising involve little capital investment but distrib-
of the overall MNC. Proper incentives and com- ute some of the profits to other parties. The
munication from the parent may help to ensure acquisition of foreign firms or formation of foreign
that subsidiary managers focus on serving the subsidiaries requires substantial capital invest-
overall MNC. ments but offers the potential for large returns.
■ International business is justified by three key ■ The valuation model of an MNC shows that the
theories. The theory of comparative advantage MNC’s value is favorably affected when its ex-
suggests that each country should use its com- pected foreign cash inflows increase, the currencies
parative advantage to specialize in its production denominating those cash inflows increase, or the
and rely on other countries to meet other needs. MNC’s required rate of return decreases. Con-
The imperfect markets theory suggests that im- versely, the MNC’s value is adversely affected
perfect markets render the factors of production when its expected foreign cash inflows decrease,
immobile, which encourages countries to spe- the values of currencies denominating those cash
cialize based on the resources they have. The flows decrease (assuming that they have net cash
product cycle theory suggests that, after firms inflows in foreign currencies), or the MNC’s
are established in their home countries, they required rate of return increases.

POINT COUNTER-POINT
Should an MNC Reduce Its Ethical Standards to Compete Internationally?
Point Yes. When a U.S.-based MNC competes in firms might provide payoffs to the government officials
some countries, it may encounter some business norms who will make the decision. Yet, in the United States, a
there that are not allowed in the United States. For firm will sometimes take a client on an expensive golf
example, when competing for a government contract, outing or provide skybox tickets to events. This is no

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 Chapter 1: Multinational Financial Management: An Overview 23

different than a payoff. If the payoffs are bigger in some country that allows activities that might be viewed as
foreign countries, the MNC can compete only by unethical. In this way, the MNC establishes more
matching the payoffs provided by its competitors. credibility worldwide.
Counter-Point No. A U.S.-based MNC should Who Is Correct? Use the Internet to learn more
maintain a standard code of ethics that applies to any about this issue. Which argument do you support?
country, even if it is at a disadvantage in a foreign Offer your own opinion on this issue.

SELF-TEST
Answers are provided in Appendix A at the back of 2. Explain why unfavorable economic or political
the text. conditions affect the MNC’s cash flows, required rate
of return, and valuation.
1. What are typical reasons why MNCs expand
3. Identify the more obvious risks faced by MNCs
internationally?
that expand internationally.

QUESTIONS AND APPLICATIONS

1. Agency Problems of MNCs 5. International Opportunities Due to the
a. Explain the agency problem of MNCs. Internet
b. Why might agency costs be larger for an MNC a. What factors cause some firms to become more
than for a purely domestic firm? internationalized than others?

2. Comparative Advantage b. Offer your opinion on why the Internet may result
in more international business.
a. Explain how the theory of comparative advantage
relates to the need for international business. 6. Impact of Exchange Rate Movements Plak Co.
of Chicago has several European subsidiaries that remit
b. Explain how the product cycle theory relates to the earnings to it each year. Explain how appreciation of
growth of an MNC. the euro (the currency used in many European coun-
3. Imperfect Markets tries) would affect Plak’s valuation.
a. Explain how the existence of imperfect markets has 7. Benefits and Risks of International Business
led to the establishment of subsidiaries in foreign As an overall review of this chapter, identify possible
markets. reasons for growth in international business. Then, list
b. If perfect markets existed, would wages, prices, and the various disadvantages that may discourage inter-
interest rates among countries be more similar or less national business.
similar than under conditions of imperfect markets? 8. Valuation of an MNC Hudson Co., a U.S. firm,
Why? has a subsidiary in Mexico, where political risk has
4. International Opportunities recently increased. Hudson’s best guess of its future
peso cash flows to be received has not changed.
a. Do you think the acquisition of a foreign firm However, its valuation has declined as a result of the
or licensing will result in greater growth for an increase in political risk. Explain.
MNC? Which alternative is likely to have
more risk? 9. Centralization and Agency Costs Would the
agency problem be more pronounced for Berkely
b. Describe a scenario in which the size of a corpo- Corp., whose parent company makes most major
ration is not affected by access to international decisions for its foreign subsidiaries, or Oakland Corp.,
opportunities. which uses a decentralized approach?
c. Explain why MNCs such as Coca-Cola and Pep- 10. Global Competition Explain why more stan-
siCo, Inc., still have numerous opportunities for inter- dardized product specifications across countries can
national expansion. increase global competition.

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24 Part 1: The International Financial Environment

11. Exposure to Exchange Rates McCanna Corp., a b. Explain how the joint venture limited the risk of
U.S. firm, has a French subsidiary that produces wine the international business.
and exports to various European countries. All of the c. Many international joint ventures are intended to
countries where it sells its wine use the euro as their circumvent barriers that normally prevent foreign
currency, which is the same currency used in France. competition. What barrier in Japan did Anheuser-
Is McCanna Corp. exposed to exchange rate risk? Busch circumvent as a result of the joint venture? What
12. Macro versus Micro Topics Review the Table of barrier in the United States did Kirin circumvent as a
Contents and indicate whether each of the chapters result of the joint venture?
from Chapter 2 through Chapter 21 has a macro or d. Explain how Anheuser-Busch could have lost some
micro perspective. of its market share in countries outside Japan as a
13. Methods Used to Conduct International result of this particular joint venture.
Business Duve, Inc., desires to penetrate a foreign 18. Impact of Eastern European Growth The
market with either a licensing agreement with a foreign managers of Loyola Corp. recently had a meeting to
firm or by acquiring a foreign firm. Explain the dif- discuss new opportunities in Europe as a result of the
ferences in potential risk and return between a licens- recent integration among Eastern European countries.
ing agreement with a foreign firm and the acquisition They decided not to penetrate new markets because of
of a foreign firm. their present focus on expanding market share in the
14. International Business Methods Snyder Golf United States. Loyola’s financial managers have devel-
Co., a U.S. firm that sells high-quality golf clubs in the oped forecasts for earnings based on the 12 percent
United States, wants to expand internationally by sell- market share (defined here as its percentage of total
ing the same golf clubs in Brazil. European sales) that Loyola currently has in Eastern
a. Describe the tradeoffs that are involved for each Europe. Is 12 percent an appropriate estimate for next
method (such as exporting, direct foreign investment, year’s Eastern European market share? If not, does it
etc.) that Snyder could use to achieve its goal. likely overestimate or underestimate the actual Eastern
European market share next year?
b. Which method would you recommend for this
firm? Justify your recommendation. 19. Valuation of an MNC Birm Co., based in Ala-
bama, is considering several international opportunities
15. Impact of Political Risk Explain why political in Europe that could affect the value of its firm. The
risk may discourage international business. valuation of its firm is dependent on four factors:
16. Impact of September 11 Following the terrorist (1) expected cash flows in dollars, (2) expected cash
attack on the United States, the valuations of many flows in euros that are ultimately converted into dollars,
MNCs declined by more than 10 percent. Explain why (3) the rate at which it can convert euros to dollars, and
the expected cash flows of MNCs were reduced, even if (4) Birm’s weighted average cost of capital. For each
they were not directly hit by the terrorist attacks. opportunity, identify the factors that would be affected.
a. Birm plans a licensing deal in which it will sell
Advanced Questions
technology to a firm in Germany for $3 million; the
17. International Joint Venture Anheuser-Busch payment is invoiced in dollars, and this project has the
(which is now part of AB InBev due to a merger), the same risk level as its existing businesses.
producer of Budweiser and other beers, has engaged in
b. Birm plans to acquire a large firm in Portugal that
a joint venture with Kirin Brewery, the largest brewery
is riskier than its existing businesses.
in Japan. The joint venture enabled Anheuser-Busch to
have its beer distributed through Kirin’s distribution c. Birm plans to discontinue its relationship with a
channels in Japan. In addition, it could utilize Kirin’s U.S. supplier so that it can import a small amount of
facilities to produce beer that would be sold locally. In supplies (denominated in euros) at a lower cost from a
return, Anheuser-Busch provided information about Belgian supplier.
the American beer market to Kirin. d. Birm plans to export a small amount of materials
a. Explain how the joint venture enabled Anheuser- to Ireland that are denominated in euros.
Busch to achieve its objective of maximizing share- 20. Assessing Motives for International Business
holder wealth. Fort Worth, Inc., specializes in manufacturing some

Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 Chapter 1: Multinational Financial Management: An Overview 25

basic parts for sports utility vehicles (SUVs) that are in tours for American tourists. Until recently, all of its
produced and sold in the United States. Its main ad- business was in the United States. It just established a
vantage in the United States is that its production is subsidiary in Athens, Greece, which provides tour ser-
efficient and less costly than that of some other vices in the Greek islands for American tourists. It
unionized manufacturers. It has a substantial market rented a shop near the port of Athens. It also hired
share in the United States. Its manufacturing process is residents of Athens who could speak English and pro-
labor intensive. It pays relatively low wages compared vide tours of the Greek islands. The subsidiary’s main
to U. S. competitors, but has guaranteed the local costs are rent and salaries for its employees and the
workers that their positions will not be eliminated for lease of a few large boats in Athens that it uses for
the next 30 years. It hired a consultant to determine tours. American tourists pay for the entire tour in
whether it should set up a subsidiary in Mexico, where dollars at Nantucket’s main U.S. office before they
the parts would be produced. The consultant suggested depart for Greece.
that Fort Worth should expand for the following rea- a. Explain why Nantucket may be able to effectively
sons. Offer your opinion on whether the consultant’s capitalize on international opportunities such as the
reasons are logical. Greek island tours.
a. Theory of Competitive Advantage: There are not b. Nantucket is privately owned by owners who re-
many SUVs sold in Mexico, so Fort Worth, Inc., would side in the United States and work in the main office.
not have to face much competition there. Explain possible agency problems associated with the
b. Imperfect Markets Theory: Fort Worth cannot creation of a subsidiary in Athens, Greece. How can
easily transfer workers to Mexico, but it can establish a Nantucket attempt to reduce these agency costs?
subsidiary there in order to penetrate a new market. c. Greece’s cost of labor and rent are relatively low.
c. Product Cycle Theory: Fort Worth has been suc- Explain why this information is relevant to Nantucket’s
cessful in the United States. It has limited growth oppor- decision to establish a tour business in Greece.
tunities because it already controls much of the U.S. d. Explain how the cash flow situation of the Greek
market for the parts it produces. Thus, the natural next tour business exposes Nantucket to exchange rate risk.
step is to conduct the same business in a foreign country. Is Nantucket favorably or unfavorably affected when
d. Exchange Rate Risk: The exchange rate of the peso the euro (Greece’s currency) appreciates against the
has weakened recently, so this would allow Fort Worth dollar? Explain.
to build a plant at a very low cost (by exchanging e. Nantucket plans to finance its Greek tour business.
dollars for the cheap pesos to build the plant). Its subsidiary could obtain loans in euros from a bank
e. Political Risk: The political conditions in Mexico in Greece to cover its rent, and its main office could
have stabilized in the last few months, so Fort Worth pay off the loans over time. Alternatively, its main of-
should attempt to penetrate the Mexican market now. fice could borrow dollars and would periodically con-
21. Valuation of Walmart’s International vert dollars to euros to pay the expenses in Greece.
Business In addition to all of its stores in the United Does either type of loan reduce the exposure of Nan-
States, Walmart Stores, Inc. has 13 stores in Argentina, tucket to exchange rate risk? Explain.
302 stores in Brazil, 289 stores in Canada, 73 stores in f. Explain how the Greek island tour business could
China, 889 stores in Mexico, and 335 stores in the expose Nantucket to political country risk.
United Kingdom. Overall, it has 2,750 stores in foreign 23. Valuation of an MNC Yahoo! has expanded its
countries. Consider that the value of Walmart is com- business by establishing portals in numerous countries,
posed of two parts, a U.S. part (due to business in the including Argentina, Australia, China, Germany, Ire-
United States) and a non-U.S. part (due to business in land, Japan, and the United Kingdom. It has cash
other countries). Explain how to determine the present outflows associated with the creation and administra-
value (in dollars) of the non-U.S. part assuming that tion of each portal. It also generates cash inflows from
you had access to all the details of Walmart businesses selling advertising space on its website. Each portal
outside the United States. results in cash flows in a different currency. Thus, the
22. Impact of International Business on Cash valuation of Yahoo! is based on its expected future net
Flows and Risk Nantucket Travel Agency specializes cash flows in Argentine pesos after converting them

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26 Part 1: The International Financial Environment

into U.S. dollars, its expected net cash flows in Aus- 10 million euros in each of the next 10 years. It will
tralian dollars after converting them into U.S. dollars, need to obtain 2 million Mexican pesos in each of the
and so on. Explain how and why the valuation of Ya- next 10 years. The euro exchange rate is presently val-
hoo! would change if most investors suddenly expected ued at $1.38 and is expected to depreciate by 2 percent
that the dollar would weaken against most currencies each year over time. The peso is valued at $.13 and is
over time. expected to depreciate by 2 percent each year over
24. Uncertainty Surrounding an MNC’s Valuation time. Review the valuation equation for an MNC. Do
Carlisle Co. is a U.S. firm that is about to purchase a you think that the exchange rate movements will have
large company in Switzerland at a purchase price of a favorable or unfavorable effect on the MNC?
$20 million. This company produces furniture and sells 28. Impact of the Credit Crisis on MNC Value
it locally (in Switzerland), and it is expected to earn Much of the attention to the credit crisis was focused
large profits every year. The company will become a on its adverse effects on financial institutions. Yet,
subsidiary of Carlisle and will periodically remit its many other types of firms were affected as well. Explain
excess cash flows due to its profits to Carlisle Co. As- why the numerator of the MNC valuation equation was
sume that Carlisle Co. has no other international affected during the October 6–10, 2008, period. Explain
business. Carlisle has $10 million that it will use to pay how the denominator of the MNC valuation equation
for part of the Swiss company and will finance the rest was affected during this period.
of its purchase with borrowed dollars. Carlisle Co. can 29. Exposure of MNCs to Exchange Rate
obtain supplies from either a U.S. supplier or a Swiss Movements Because of the low labor costs in
supplier (in which case the payment would be made in Thailand, Melnick Co. (based in the United States)
Swiss francs). Both suppliers are very reputable and recently established a major research and development
there would be no exposure to country risk when using subsidiary there that it owns. The subsidiary was cre-
either supplier. Is the valuation of the total cash flows ated to improve new products that the parent of
of Carlisle Co. more uncertain if it obtains its supplies Melnick can sell in the United States (denominated in
from a U.S. firm or a Swiss firm? Explain briefly. dollars) to U.S. customers. The subsidiary pays its local
25. Impact of Exchange Rates on MNC Value employees in baht (the Thai currency). The subsidiary
Olmsted Co. has small computer chips assembled in has a small amount of sales denominated in baht, but
Poland and transports the final assembled products to its expenses are much larger than its revenue. It has
the parent, where they are sold by the parent in the just obtained a large loan denominated in baht that will
United States. The assembled products are invoiced in be used to expand its subsidiary. The business that the
dollars. Olmsted Co. uses Polish currency (the zloty) to parent of Melnick Co. conducts in the United States is
produce these chips and assemble them in Poland. The not exposed to exchange rate risk. If the Thai baht
Polish subsidiary pays the employees in the local cur- weakens over the next 3 years, will the value of Melnick
rency (zloty), and Olmsted Co. finances its subsidiary Co. be favorably affected, unfavorably affected, or not
operations with loans from a Polish bank (in zloty). The affected? Briefly explain.
parent of Olmsted will send sufficient monthly pay- 30. Shareholder Rights of Investors in MNCs
ments (in dollars) to the subsidiary in order to repay the MNCs tend to expand more when they can more easily
loan and other expenses incurred by the subsidiary. If access funds by issuing stock. In some countries,
the Polish zloty depreciates against the dollar over time, shareholder rights are very limited, and the MNCs have
will that have a favorable, unfavorable, or neutral effect limited ability to raise funds by issuing stock. Explain
on the value of Olmsted Co.? Briefly explain. why access to funding is more severe for MNCs based
26. Impact of Uncertainty on MNC Value Min- in countries where shareholder rights are limited.
neapolis Co. is a major exporter of products to Canada. 31. MNC Cash Flows and Exchange Rate Risk
Today, an event occurred that has increased the un- Tuscaloosa Co. is a U.S. firm that assembles phones in
certainty surrounding the Canadian dollar’s future Argentina and transports the final assembled products
value over the long term. Explain how this event can to the parent, where they are sold by the parent in the
affect the valuation of Minneapolis Co. United States. The assembled products are invoiced in
27. Exposure of MNCs to Exchange Rate dollars. The Argentine subsidiary obtains some mate-
Movements Arlington Co. expects to receive rial from China, and the Chinese exporter is willing to

Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 Chapter 1: Multinational Financial Management: An Overview 27

accept Argentine pesos as payment for these materials b. Assume that Concord Co. (a U.S. firm) is in the
that it exports. The Argentine subsidiary pays its em- same industry as Bangor Co. There is no political risk
ployees in the local currency (pesos), and finances its that could have any impact on the cash flows of either
operations with loans from an Argentine bank (in pe- firm. Concord Co. knows that it will have cash inflows
sos). Tuscaloosa Co. has no other international busi- of $900,000 from domestic operations, cash inflows of
ness. If the Argentine peso depreciates against the 700,000 Swiss francs due to exports to Swiss operations,
dollar over time, will that have a favorable, unfavorable, and cash outflows of 800,000 Swiss francs at the end of
or neutral effect on Tuscaloosa Co.? Briefly explain. the year. Is the valuation of the total cash flows of
32. MNC Cash Flows and Exchange Rate Risk Concord Co. more uncertain or less uncertain than the
Asheville Co. has a subsidiary in Mexico that develops total cash flows of Bangor Co.? Explain briefly.
software for its parent. It rents a large facility in Mexico 35. Valuation of an MNC Odessa Co., Midland Co.,
and hires many people in Mexico to work in the facil- and Roswell Co. are U.S. firms in the same industry
ity. Asheville Co. has no other international business. and have the same valuation as of yesterday, based on
All operations are presently funded by Asheville’s par- the present value of future cash flows of each company.
ent. All the software is sold to U.S. firms by Asheville’s Odessa Co. obtains a large amount of its supplies in-
parent and invoiced in U.S. dollars. voiced in euros from European countries, and all of its
a. If the Mexican peso appreciates against the dollar, sales are invoiced in dollars. Midland has a large sub-
does this have a favorable effect, unfavorable effect, or sidiary in Europe that does all of its business in euros
no effect on Asheville’s value? and remits profits to the U.S. parent every year. Ros-
well Co. has no international business. Assume that as
b. Asheville Co. plans to borrow funds to support its of this morning an event occurred that you believe will
expansion in the United States. The Mexican interest cause a substantial depreciation of the euro against the
rates are presently lower than U.S. interest rates, so dollar over time. Assume that this event will not
Asheville obtains a loan denominated in Mexican pesos change the business operations of the firms mentioned
in order to support its expansion in the United States. in this question. Which firm will have the highest val-
Will the borrowing of pesos increase, decrease, or have uation based on your expectations? Briefly explain.
no effect on its exposure to exchange rate risk? Briefly
explain. 36. Impact of Uncertainty on an MNC’s
Valuation Assume that Alpine Co. is a U.S. firm that
33. Estimating an MNC’s Cash Flows Biloxi Co. is has direct foreign investment in Brazil as a result es-
a U.S. firm that has a subsidiary in China. The sub- tablishing a subsidiary there. Political conditions have
sidiary reinvests half of its net cash flows into opera- changed in Brazil, but the best guess by investors of the
tions and remits half to the parent. Biloxi Co. has future cash flows per year for Alpine Co. has not
expected cash flows from domestic business equal to changed. Yet, there is more uncertainty surrounding
$10,000,000 and the Chinese subsidiary is expected to the best guess of Alpine’s cash flows. In other words,
generate 100 million Chinese yuan at the end of the the distribution of possible outcomes above and
year. The expected value of yuan at the end of the year below the best guess has expanded. Would the change
is $.13. What are the expected dollar cash flows of the in uncertainty cause the prevailing value of Alpine Co.
parent of Biloxi Co. in one year? to increase, decrease, or remain unchanged? Briefly
34. Uncertainty Surrounding an MNC’s Cash explain.
Flows 37. Exposure of MNC Cash Flows
a. Assume that Bangor Co. (a U.S. firm) knows that it a. Rochester Co. is a U.S. firm that has a language
will have cash inflows of $900,000 from domestic op- institute in France. This institute attracts Americans
erations, cash inflows of 200,000 Swiss francs due to who want to learn the French language. Rochester Co.
exports to Swiss operations, and cash outflows of charges tuition to the American students in dollars. It
500,000 Swiss francs at the end of the year. While the expects that its dollar revenue from charging tuition
future value of the Swiss franc is uncertain because it will be stable over each of the next several years. Its
fluctuates, your best guess is that the Swiss franc’s value total expenses for this project are as follows. It rents a
will be $1.10 at the end this year. What are the ex- facility in Paris, and makes a large rent payment each
pected dollar cash flows of Bangor Co? month in euros. It also hires several French citizens as

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28 Part 1: The International Financial Environment

full-time instructors, and pays their salary in euros. It annual revenue is just slightly larger than the expected
expects that its expenses denominated in euros will be annual expenses. Is the valuation of net cash flows
stable over each of the next several years. If the euro subject to a higher degree of exchange rate risk for this
appreciates against the dollar over time, should this project or for the project for American students?
have a favorable effect, unfavorable effect, or no effect Briefly explain.
on the value of Rochester Co.? Briefly explain.
Discussion in the Boardroom
b. Rochester considers a new project in which it
would also attract people from Spain, and the institute This exercise can be found in Appendix E at the back
in France would teach them the French language. It of this textbook.
would charge them tuition in euros. The expenses for
this project would be about the same as the expenses of Running Your Own MNC
the project described above for the American students.
This exercise can be found on the International Finan-
Assume that euros to be generated by this project
cial Management text companion website. Go to www.
would be stable over the next several years. Assume
cengagebrain.com (students) or www.cengage.com/login
that this project is about the same size as the project for
(instructors) and search using ISBN 9781133947837.
American students. For either project, the expected

BLADES, INC. CASE

Decision to Expand Internationally
Blades, Inc., is a U.S.-based company that has been Furthermore, and because of these limitations, expan-
incorporated in the United States for 3 years. Blades sion within the United States at this time seems
is a relatively small company, with total assets of only pointless.
$200 million. The company produces a single type of Holt is considering the following: If Blades cannot
product, roller blades. Due to the booming roller blade penetrate the U.S. market further or reduce costs here,
market in the United States at the time of the com- why not import some parts from overseas and/or
pany’s establishment, Blades has been quite successful. expand the company’s sales to foreign countries? Simi-
For example, in its first year of operation, it reported a lar strategies have proved successful for numerous
net income of $3.5 million. Recently, however, the de- companies that expanded into Asia in recent years to
mand for Blades’ “Speedos,” the company’s primary increase their profit margins. The CFO’s initial focus is
product in the United States, has been slowly tapering on Thailand. Thailand has recently experienced weak
off, and Blades has not been performing well. Last year, economic conditions, and Blades could purchase com-
it reported a return on assets of only 7 percent. In re- ponents there at a low cost. Holt is aware that many of
sponse to the company’s annual report for its most Blades’ competitors have begun importing production
recent year of operations, Blades’ shareholders have components from Thailand.
been pressuring the company to improve its perfor- Not only would Blades be able to reduce costs by
mance; its stock price has fallen from a high of $20 importing rubber and/or plastic from Thailand due to
per share 3 years ago to $12 last year. Blades produces the low costs of these inputs, but it might also be able
high-quality roller blades and employs a unique pro- to augment weak U.S. sales by exporting to Thailand,
duction process, but the prices it charges are among an economy still in its infancy and just beginning to
the top 5 percent in the industry. appreciate leisure products such as roller blades. While
In light of these circumstances, Ben Holt, the com- several of Blades’ competitors import components from
pany’s chief financial officer (CFO), is contemplating Thailand, few are exporting to the country. Long-term
his alternatives for Blades’ future. There are no other decisions would also eventually have to be made;
cost-cutting measures that Blades can implement in the maybe Blades, Inc., could establish a subsidiary in
United States without affecting the quality of its prod- Thailand and gradually shift its focus away from the
uct. Also, production of alternative products would re- United States if its U.S. sales do not rebound. Establish-
quire major modifications to the existing plant setup. ing a subsidiary in Thailand would also make sense for

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 Chapter 1: Multinational Financial Management: An Overview 29

Blades due to its superior production process. Holt is country. Holt has presented you with a list of initial
reasonably sure that Thai firms could not duplicate the questions you should answer.
high-quality production process employed by Blades.
1. What are the advantages Blades could gain from
Furthermore, if the company’s initial approach of ex-
importing from and/ or exporting to a foreign country
porting works well, establishing a subsidiary in Thai-
such as Thailand?
land would preserve Blades’ sales before Thai
2. What are some of the disadvantages Blades could
competitors are able to penetrate the Thai market.
face as a result of foreign trade in the short run? In the
As a financial analyst for Blades, Inc., you are as-
long run?
signed to analyze international opportunities and risk
3. Which theories of international business described
resulting from international business. Your initial as-
in this chapter apply to Blades, Inc., in the short run?
sessment should focus on the barriers and opportu-
In the long run?
nities that international trade may offer. Holt has
4. What long-range plans other than establishment of
never been involved in international business in any
a subsidiary in Thailand are an option for Blades and
form and is unfamiliar with any constraints that may
may be more suitable for the company?
inhibit his plan to export to and import from a foreign

SMALL BUSINESS DILEMMA

Developing a Multinational Sporting Goods Corporation
In every chapter of this text, some of the key concepts believe that he could compete with this firm in the U.S.
are illustrated with an application to a small sporting market.
goods firm that conducts international business. These Rather than pursue a different business, Logan de-
“Small Business Dilemma” features allow students to cided to implement his idea on a global basis. While
recognize the dilemmas and possible decisions that football (as it is played in the United States) has not
firms (such as this sporting goods firm) may face in a been a traditional sport in foreign countries, it has be-
global environment. For this chapter, the application is come more popular in some foreign countries in recent
on the development of the sporting goods firm that years. Furthermore, the expansion of cable networks in
would conduct international business. foreign countries would allow for much more exposure
Last month, Jim Logan completed his undergradu- to U.S. football games in those countries in the future.
ate degree in finance and decided to pursue his dream To the extent that this would increase the popularity of
of managing his own sporting goods business. Logan football (U.S. style) as a hobby in the foreign countries,
had worked in a sporting goods shop while going to it would result in a demand for footballs in foreign
college, and he had noticed that many customers countries. Logan asked many of his foreign friends
wanted to purchase a low-priced football. However, from college days if they recalled seeing footballs sold
the sporting goods store where he worked, like many in their home countries. Most of them said they rarely
others, sold only top-of-the-line footballs. From his ex- noticed footballs being sold in sporting goods stores but
perience, Logan was aware that top-of-the-line foot- that they expected the demand for footballs to increase
balls had a high markup and that a low-cost football in their home countries. Consequently, Logan decided to
could possibly penetrate the U.S. market. He also knew start a business of producing low-priced footballs and
how to produce footballs. His goal was to create a firm exporting them to sporting goods distributors in foreign
that would produce low-priced footballs and sell them countries. Those distributors would then sell the foot-
on a wholesale basis to various sporting goods stores in balls at the retail level. Logan planned to expand his
the United States. Unfortunately, many sporting goods product line over time once he identified other sports
stores began to sell low-priced footballs just before Lo- products that he might sell to foreign sporting goods
gan was about to start his business. The firm that began stores. He decided to call his business “Sports Exports
to produce the low-cost footballs already provided Company.” To avoid any rent and labor expenses, Logan
many other products to sporting goods stores in the planned to produce the footballs in his garage and to
United States and therefore had already established a perform the work himself. Thus, his main business ex-
business relationship with these stores. Logan did not penses were the cost of the materials used to produce

Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
30 Part 1: The International Financial Environment

footballs and expenses associated with finding distribu- 4. How would Jim Logan decide which foreign mar-
tors in foreign countries who would attempt to sell the kets he would attempt to enter? Should he initially fo-
footballs to sporting goods stores. cus on one or many foreign markets?
5. The Sports Exports Company has no immediate
1. Is Sports Exports Company a multinational
plans to conduct direct foreign investment. However, it
corporation?
might consider other less costly methods of establish-
2. Why are the agency costs lower for Sports Exports
ing its business in foreign markets. What methods
Company than for most MNCs?
might the Sports Exports Company use to increase its
3. Does Sports Exports Company have any compara-
presence in foreign markets by working with one or
tive advantage over potential competitors in foreign
more foreign companies?
countries that could produce and sell footballs there?

INTERNET/EXCEL EXERCISES
The website address of the Bureau of Economic DFI in France. Offer a possible reason for the large
Analysis is www.bea.gov. difference.
2. Based on the recent trends in DFI, are U.S.-based
1. Use this website to assess recent trends in direct
MNCs pursuing opportunities in Asia? In Eastern
foreign investment (DFI) abroad by U.S. firms.
Europe? In Latin America?
Compare the DFI in the United Kingdom with the

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent article online that describes an actual search terms (and include the current year as a search
international finance application or a real-world ex- term to ensure that the online articles are recent).
ample about a specific MNC’s actions that reinforces
1. company AND repatriated foreign earnings
one or more of the concepts covered in this chapter.
2. Inc. AND repatriated foreign earnings
If your class has an online component, your profes-
3. company AND currency effects
sor may ask you to post your summary there and pro-
4. Inc. AND currency effects
vide the Web link of the article so that other students
5. company AND country risk
can access it. If your class is live, your professor may
6. Inc. AND country risk
ask you to summarize your application in class. Your
7. direct foreign investment
professor may assign specific students to complete this
8. joint venture AND international
assignment for this chapter or may allow any students
9. licensing AND international
to do the assignment on a volunteer basis.
10. multinational corporation AND risk
For recent online articles and real-world examples
applied to this chapter, consider using the following

Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.