Chapter 1

Multinational Financial
Management: An Overview

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Chapter Objectives
• Identify the management goal and organizational structure of the
Multinational Corporation (MNC).
• Describe the key theories that justify international business.
• Explain the common methods used to conduct international business.
• Provide a model for valuing the MNC.

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Managing the MNC (1 of 4)
Managers are expected to make decisions that will maximize the stock price.
Focus of this text: MNCs whose parents fully own foreign subsidiaries (U.S.
parent is sole owner of subsidiary).

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Managing the MNC (2 of 4)
How Business Disciplines Are Used to Manage the M NC
• Common finance decisions include:
o Whether to discontinue operations in a particular country
o Whether to pursue new business in a particular country
o Whether to expand business in a particular country
o How to finance expansion in a particular country
• Finance decisions are influenced by other business discipline functions:
o Marketing
o Management
o Accounting and information systems

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Managing the MNC (3 of 4)
Agency Problems
• The conflict of goals between managers and shareholders
• Agency Costs
o Definition: Cost of ensuring that managers maximize shareholder wealth.
o Costs are normally higher for MNCs than for purely domestic firms for several
reasons:
• Monitoring managers of distant subsidiaries in foreign countries is more difficult.
• Foreign subsidiary managers raised in different cultures may not follow uniform
goals.
• Sheer size of larger MNCs can create large agency problems.

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Managing the MNC (4 of 4)
Agency Problems (continued)
• Parent control of agency problems
o Parent should clearly communicate the goals for each subsidiary to ensure
managers focus on maximizing the value of the subsidiary.
• Corporate control of agency problems
o Entire management of the MNC must be focused on maximizing shareholder
wealth.
• Sarbanes-Oxley Act (SOX)
o Ensures a more transparent process for managers to report on the productivity
and financial condition of their firm.

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SOX Methods to Improve Reporting
Agency Problems (continued)
• How SOX Improved Corporate Governance of MNCs
o Establishing a centralized database of information
o Ensuring that all data are reported consistently among subsidiaries
o Implementing a system that automatically checks for unusual discrepancies
relative to norms
o Speeding the process by which all departments and subsidiaries have access to
all the data they need
o Making executives more accountable for financial statements

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Management Structure of MNC
Management Structure of MNC
The magnitude of agency costs varies with the MNC’s management style.
• Centralized management style (See Exhibit 1.1a)
o Allows managers of the parent to control foreign subsidiaries and therefore
reduce the power of subsidiary managers.
o Reduce agency costs
• Decentralized management style (See Exhibit 1.1b)
o Gives more control to subsidiary managers who are closer to the subsidiary’s
operation and environment.
o Increase agency costs

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Exhibit 1.1a Management Styles of MNCs

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Exhibit 1.1b Management Styles of MNCs

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Why MNCs Pursue International Business (1 of 4)
Theory of Competitive Advantage: Specialization increases production
efficiency.
Imperfect Markets Theory: Factors of production are somewhat immobile,
providing incentive to seek out foreign opportunities.
Product Cycle Theory: As a firm matures, it recognizes opportunities outside
its domestic market. (Exhibit 1.2)

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Why MNCs Pursue International Business (2 of 4)
Theory of Competitive Advantage
• Some countries have a technology advantage and other countries have an
advantage in the cost of basic labor.
• Countries tend to use their advantages to specialize in the production of
goods that can be produced with relative efficiency.
• A country that specializes in some products may not produce other products,
so trade between countries is essential.
• Comparative advantages allow firms to penetrate foreign market

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Why MNCs Pursue International Business (3 of 4)
Imperfect Markets Theory
• If each country’s markets were closed to all other countries:
o There would be no international business.
• In extreme case, if markets are perfect then the factors of production are
easily transferable:
o This eliminates the comparative cost advantage which is rationale for
international trade.
• In real world, market are imperfect where factors of production are somewhat
immobile:
o Costs and often other restrictions affect the transfer of labor and other resources
used for production
o Provide an incentive for firms to seek out foreign opportunities

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Why MNCs Pursue International Business (4 of 4)
Product cycle theory (Exhibit 1.2.):
• According to this theory, Firm first established its operation in home market:
o Because information about home markets and competition is more readily
available.
• Firm’s product is perceived by foreign consumers to be superior to that
available within their own countries, the firm may accommodate foreign
consumers by exporting.
• If the firm’s product becomes very popular in foreign countries, it may
produce the product in foreign markets, thereby reducing its transportation
costs.
• Firm’s foreign business diminishes or expands over time will depend on how
successful it is at maintaining some advantage over its competition.

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Exhibit 1.2 International Product Life Cycles

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How Firms Engage in International Business (1 of 9)
International Trade
Licensing
Franchising
Joint Ventures
Acquisitions of Existing Operations
Establishment of New Foreign Subsidiaries

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How Firms Engage in International Business (2 of 9)
International Trade
• Relatively conservative approach that can be used by firms to:
o penetrate markets (by exporting).
o obtain supplies at a low cost (by importing).
• Minimal risk — no capital at risk

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How Firms Engage in International Business (3 of 9)
Licensing
• Obligates a firm to provide its technology (copyrights, trademarks, or trade
names) in exchange for fees or some other specified benefits.
• Firm able to generate more revenue from foreign countries without
establishing any production plants in foreign countries or transporting goods
to foreign countries.

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How Firms Engage in International Business (4 of 9)
Franchising
• Obligates firm to provide a specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange for
periodic fees.
• Franchising by an MNC often requires a direct investment in foreign
operations, it is referred to as a direct foreign investment.

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How Firms Engage in International Business (5 of 9)
Joint Ventures
• A venture that is jointly owned and operated by two or more firms.
• A firm may enter the foreign market by engaging in a joint venture with firms
that reside in those markets.
• Allows two firms to apply their respective cooperative advantages in a given
project.

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How Firms Engage in International Business (6 of 9)
Acquisitions of Existing Operations
• Acquisitions of firms in foreign countries allows firms to have full control over
their foreign businesses and to quickly obtain a large portion of foreign
market share.
• Subject to the risk of large losses because of larger investment.
• Liquidation may be difficult if the foreign subsidiary performs poorly.
• Partial international acquisitions requires a smaller investment and limits the
potential loss to the firm if the project fails.
• firm will not have complete control over foreign operations that are only
partially acquired

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How Firms Engage in International Business (7 of 9)
Establishment of New Foreign Subsidiaries
• Firms can penetrate markets by establishing new operations in foreign
countries.
• Large investment required.
• Operations can be tailored exactly to the firm’s needs.
• Firm will not reap any rewards from the investment until the subsidiary is built
and a customer base established.

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How Firms Engage in International Business (9 of 9)
Summary of Methods (continued)
• Exhibit 1.3 Cash Flow Diagrams for MNCs
o The first diagram reflects an MNC that engages in international trade.
International cash flows result from paying for imports or receiving cash flow from
exports.
o The second diagram reflects an MNC that engages in some international
arrangements. Outflows include expenses such as expenses incurred from
transferring technology or funding partial investment in a franchise or joint
venture. Inflows are receipts from fees.
o The third diagram reflects an MNC that engages in direct foreign investment.
Cash flows exist between the parent company and the foreign subsidiary.

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Exhibit 1.3 Cash Flow Diagrams for MNCs

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Valuation Model for an MNC (1 of 6)
Domestic Model

Where
• V represents present value of expected cash flows
• E(CF$,t) represents expected cash flows to be received at the end of period t,
• n represents the number of periods into the future in which cash flows are
received, and
• k represents the required rate of return by investors.

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Valuation Model for an MNC (2 of 6)
Domestic Model (continued)
• Dollar Cash Flows
o 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.
• Cost of Capital
o The required rate of return (k) in the denominator of the valuation equation.
o A weighted average of the cost of capital based on all the firms projects.

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Valuation Model for an MNC (3 of 6)
Multinational Model

Where
• CFj,t represents the amount of cash flow denominated in a particular foreign
currency j at the end of period t,
• Sj,t represents the exchange rate at which the foreign currency (measured in
dollars per unit of the foreign currency) can be converted to dollars at the end
of period t.

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Valuation Model for an MNC (4 of 6)
Multinational Model (continued)
• Valuation of an MNC that uses two currencies
o 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 would be converted to dollars and then summing those two products.
• Valuation of an MNC that uses multiple currencies

o Derive an expected dollar cash flow value for each currency

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Valuation Model for an MNC (5 of 6)
Multinational Model (continued)
• Valuation of an MNC’s cash flows over multiple periods
o Apply single period process to all future periods
o Discount the estimated total dollar cash flow for each period at the weighted cost
of capital

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Example 1.1
Suppose that, at the end of the next time period tt, a U.S.-based MNC parent named
California Co. expects to receive cash flows from it’s local business as well as from a
subsidiary located in Mexico. At the end of time period tt, the cash flow expected from the
local business is expected to be $200,000 while the cash flow expected from the subsidiary
in Mexico is expected to be 900,000 pesos. Assume the exchange rate for pesos is $0.15
per peso.

The total expected cash flows received by this MNC at the end of period tt, in dollars

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Example 1.2
Now suppose that, at the end of the next time period tt, California Co. expects cash flows
from subsidiaries in located both Mexico as well as the UK, in addition to cash flows from the
local business in the United States. At the end of time period tt, the cash flow expected from
the local business is expected to be $200,000 while the cash flow expected from the
subsidiary in Mexico is expected to be 900,000 pesos, which is equivalent to $135,000 at
the exchange rate of $0.15 per peso

If the expected cash flow from the UK subsidiary is 1,000,000 euros, and the exchange rate
is forecasted to be $0.80 per euro, then the total expected cash flows for California Co., in
dollars, are

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Organization of the Text (Exhibit 1.6)
Chapters 2-8 discuss international markets and conditions from a
macroeconomic perspective focusing on external forces that can affect the
value of an MNC
Chapters 9-21 take a microeconomic perspective and focus on how the
financial management of an MNC can affect its value

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Exhibit 1.6 Organization of Chapters

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Summary (1 of 4)
• The main goal of an MNC is to maximize shareholder wealth. When
managers are tempted to serve their own interests instead of those of
shareholders, an agency problem exists. MNCs tend to experience greater
agency problems than do domestic firms. Proper incentives and
communication from the parent may help to ensure that subsidiary managers
focus on serving the overall MNC.

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Summary (2 of 4)
International business is encouraged by three key theories.
• The theory of comparative advantage suggests that each country should use
its comparative advantage to specialize in its production and rely on other
countries to meet other needs.
• The imperfect markets theory suggests that because of imperfect markets,
factors of production are immobile, which encourages countries to specialize
based on the resources they have.
• The product cycle theory suggests that after firms are established in their
home countries, they commonly expand their product specialization in
foreign countries.

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Summary (3 of 4)
• The most common methods by which firms conduct international business
are international trade, licensing, franchising, joint ventures, acquisitions of
foreign firms, and formation of foreign subsidiaries. Methods such as
licensing and franchising involve little capital investment but distribute some
of the profits to other parties. The acquisition of foreign firms and formation of
foreign subsidiaries require substantial capital investments but offer the
potential for large returns.

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Summary (4 of 4)
• The valuation model of an MNC shows that the MNC’s value is favorably
affected when its expected foreign cash inflows increase, the currencies
denominating those cash inflows increase, or the MNC’s required rate of
return decreases. Conversely, the MNC’s value is adversely affected when
its expected foreign cash inflows decrease, the values of currencies
denominating those cash flows decrease (assuming that they have net cash
inflows in foreign currencies), or the MNC’s required rate of return increases.

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