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Lec01 Mncs

The document outlines key learning goals and topics in international finance including: 1) Explaining common theories that justify international business such as theories on currency areas and interest rate parity. 2) Describing methods used to conduct international business and factors driving the growth of international finance like increasing global trade and multinational corporations. 3) Summarizing what makes international finance special compared to domestic finance, including risks from foreign exchange and political changes, as well as opportunities from expanded global markets.
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0% found this document useful (0 votes)
37 views49 pages

Lec01 Mncs

The document outlines key learning goals and topics in international finance including: 1) Explaining common theories that justify international business such as theories on currency areas and interest rate parity. 2) Describing methods used to conduct international business and factors driving the growth of international finance like increasing global trade and multinational corporations. 3) Summarizing what makes international finance special compared to domestic finance, including risks from foreign exchange and political changes, as well as opportunities from expanded global markets.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Learning Goals

• To identify the management goal and


organizational structure of the MNC)
• To describe the key theories that justify
international business
• To explain the common methods used to
conduct international business.
• To provide a model for valuing the MNC.

A1 - 1
Finance, Corporate Finance, and
Financial Management
Finance is the field that deals with the study of how investors allocate
their assets over time under conditions of certainty and uncertainty.
OR
The system that includes the circulation of money, the granting of credit,
the making of investments, and the provision of banking facilities
(Merriam-Webster)
Corporate Finance is the task of providing the funds needed for a
corporation activities.
OR
The area of finance dealing with monetary decisions that business
enterprises make and the tools and analysis used to make these
decisions.
Financial Management refers to the efficient and effective
management of money (funds) in such a manner to accomplish the
objective of the organization.
A1 - 2
Why do we study International
Finance?
 We are living in a highly globalized and
integrated world economy
 Continued liberalization of international trade
further internationalizes the consumption pattern
 Globalized production: MNCs source inputs and
locate productions anywhere in the world
 Integrated financial markets: internationally
diversified investment, internationally tradable
financial securities

A1 - 3
International Finance
• IF is the branch of economics (international) that studies the
dynamics of
¤ exchange rates, foreign investment,
¤ International monetary system, global financial system,
¤ Issues of international financial management,
¤ and how these affect international trade.

• IF is Concerned with knowing all the procedures, techniques & tools


related to helping firm in accessing global market for short/long term
funds.
• Broadly concerned with monetary and macroeconomic interrelations
between two or more countries.
• Also referred as International Monetary Economics or International
Macroeconomics or Multinational Finance.
• It also studies international projects, international investments and
capital flows, and trade deficits. It includes the study of futures,
options and currency swaps. A1 - 4
International Finance
• Important theories in IF include
¤ The Mundell-Fleming model,
¤ The optimum currency area (OCA) theory,
¤ The purchasing power parity (PPP) theory,
¤ Interest rate parity
¤ The international Fischer Effect

A1 - 5
International Trade

• International trade is a cross border trade.


• It refers to exchange of capital, goods, services, and
across international borders or territories
• Without international trade, nations would be limited to
the goods and services produced within their own
borders
• Each country has scarce resources / specific skills –
better to produce some, rather than all – to optimize the
utilization

A1 - 6
What makes IF special?
• Three major dimensions make international finance different
from purely domestic finance:
¤ Foreign exchange and political risks
¤ Market imperfections
¤ Expanded opportunity sets

Foreign Exchange Risk


• The risk that foreign currency profits may evaporate in home
currency terms due to unanticipated unfavorable exchange rate
movements
• e.g. Recent surge in Canadian dollar value against US $.
• Unexpected fluctuations of the exchange rates may adversely
affect the MNCs as well as individuals who are engaged in cross
border transactions
• Exchange rate uncertainty may affect all the major economic
functions including consumption, production, and investment.

A1 - 7
What makes IF special?
Political Risk
¤ Sovereign governments have the right to regulate the
movement of goods, capital, and people across their
borders. These laws sometimes change in
unexpected ways.
¤ e.g. Chinese ban on canola imports from Canada in
2002 due to a fungal disease called Blackleg
¤ Sovereign country can change the rules, e.g.,
¤ Tax rules
¤ Expropriation of assets
¤ In some countries, there is a lack of tradition of the
rule of law

A1 - 8
What makes IF special?
Market imperfections
¤ Market imperfections represent various frictions and impediments
preventing markets from functioning perfectly.
¤ Such frictions/ impediments/ barriers include
- Legal restrictions on movement of goods, people & money
- Excessive transportation/shipping and transaction costs
- Information asymmetry
- Discriminatory taxation (Tax arbitrage)
¤ Often, MNCs are motivated to locate production overseas due to
such market imperfections
¤ Imperfection in the international financial market often restrict the
extent to which investors can diversify their portfolios

A1 - 9
The example of Nestlé's Market
Imperfection
• Nestlé used to issue two different classes of common stock bearer
shares and registered shares.
¤ Foreigners were only allowed to buy bearer shares (More
expensive).
¤ Swiss citizens could buy registered shares.

• On November 18, 1988, Nestlé lifted restrictions imposed on


foreigners, allowing them to hold registered shares. Following this,
the price spread between the two types of shares narrowed
dramatically.
• – This implies that there was a major transfer of wealth from foreign
shareholders to Swiss shareholders.
• Foreigners holding Nestlé bearer shares were exposed to political
risk in a country that is widely viewed as a haven from such risk. The
Nestlé episode illustrates both the importance of considering market
imperfections and the peril of political risk.
A1 - 10
What makes IF special?
Expanded opportunity set
• If firms venture into the arena of global markets, they can benefit
from an expanded opportunity set by:
¤ Locating production in any country/region of the world to
maximize performance
¤ Raising fund in any capital market where the cost of capital is the
lowest.
¤ Deploying assets on a global basis to gain from greater
economies of scale.
• It doesn’t make sense to play in only one market.
• True for corporations as well as individual investors.
• Investor’s perspective
• Risk reduction through international diversification.
• Corporation’s perspective
• Access to cheaper production inputs • Access to consumers
• Access to capital A1 - 11
Benefits of studying IF
• Among the events that affect the firm and that must be managed are
changes in exchange rates, inflation rates, interest rates, and asset
values (and these events are often themselves related)
• Because of the integration of financial markets, events in distant
lands have effects that reverberate in other regions of the world
(domino effects, contagion, systemic risk)
• Even companies with a domestic focus are affected by the global
financial environment as they compete with firms that are
internationally active
• Inflation, jobs, economic growth rates, bonds and stock prices, oil
and food prices, government revenues and other important financial
variables are all tied to exchange rates and other developments in
the increasingly integrated financial market

A1 - 12
Growing importance of IF
• Over the last decades international financial flows have grown much faster
than world GDP or world trade.
• This trend is in large parte a reflection of international trade and the process
of globalization.
• However, international financial flows have grown much faster than the real
economy.
• Between 2002 and 2007 (before the start of the current crisis international
financial flows (gross) have grown from 5% to 17% of world GDP.
• While IF contributes to world prosperity through the efficient allocation of
capital worldwide, it is also a source of concern for the challenges that it
poses for financial stability as shown by the recent financial crises.
• Financial flows are extremely volatile. After the Lehman default (gross)
international financial flows plummeted to 1% of GDP in 2008!!
• IF has become as subject of immense importance and a great deal of
attention is being payed to gain a better understanding of the way financial
markets work.

A1 - 13
Factors behind the growth of IF
• Growth of International Trade (finance associated to
commercial trade)
• Growth of Multinational Corporations (finance associated
to FDIs and M&A activity) and Multinational Banking
• Growth of the Eurodollar market
• Growth of International Finance per se (finance
associated to the growth of global saving and the need to
improve risk-return trade-offs) (Globalization

A1 - 14
Effective International Financial
Management
• Effective financial management requires an underlying
goal.
• Shareholder wealth maximization is considered as the
fundamental goal of sound financial management.
• Shareholder wealth maximization is long accepted as a
goal in the Anglo-Saxon countries like Australia, Canada,
UK, and USA.
• In other countries like France or Germany, shareholders
are viewed as merely one among many “stakeholders” of
the firm including:
¤ Employees
¤ Suppliers
¤ Customers
A1 - 15
Effective International Financial
Management
• In Japan, managers have typically sought to maximize
the value of the keiretsu—a family of firms to which the
individual firms belongs
• As a result of recent liberalization and international
integration of capital markets even the managers in
France, Germany, Japan, and other non-Anglo-Saxon
countries are beginning to pay serious attention to
shareholder wealth maximization.
• Shareholder wealth maximization does not imply that the
firm would not pursue other goals.
• Rather, shareholder wealth maximization also helps
accomplishing other legitimate goals.

A1 - 16
Effective International Financial
Management
• As shown by a series of recent corporate scandals at companies like
Enron, WorldCom, and Global Crossing, managers may pursue their
own private interests at the expense of shareholders when they are
not closely monitored.
• These calamities have painfully reinforced the importance of
corporate governance, i.e., the financial and legal framework for
regulating the relationship between a firm’s management and its
shareholders.
• These types of issues can be much more serious in many other
parts of the world, especially emerging and transitional economies,
such as Indonesia, Korea, and Russia, where legal protection of
shareholders is weak or virtually non-existing.
• No matter what the other goals, they cannot be achieved in the long
term if the maximization of shareholder wealth is not given due
consideration.

A1 - 17
Multinational Corporations (MNCs)
• Multinational corporations (MNCs) are defined as firms that
engage in some form of international business.
• More specifically, An MNC is a company that is
headquartered in one country but has operations in one or
more other countries.
• There are about 900,000 MNCs in the world. (World
Investment Report, 2017)
• Many MNCs obtain raw materials from one nation, financial
capital from another, produce goods with labor and capital
equipment in a third country, and sell their output in various
other national markets.
• The commonly accepted goal of an MNC is to maximize
shareholder wealth.

A1 - 18
MANAGING THE MNC
• How Business Disciplines Are Used to Manage
the MNC
¤ (e.g., Management, Marketing, Accounting,
Finance)
• Agency Problems
¤ Parent Control of Agency Problems
¤ Corporate Control of Agency Problems
¤ How SOX Improved Corporate Governance of
MNCs
• Management Structure of an MNC
¤ centralized and decentralized management styles

A1 - 19
How Business Disciplines Are Used to
Manage the MNC
• 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 awareness 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.
• 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.
A1 - 20
Agency Problems
• For corporations with shareholders who differ
from their managers, a conflict of goals can exist -
the agency problem.
¤ For example; A decision to expand a subsidiary may be
motivated by a manager’s desire to receive more
compensation rather than to enhance the value of the MNC.
• Agency costs are normally larger for MNCs than
for purely domestic firms for several reasons:
¤ First, 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.
A1 - 21
Agency Problems
• Facing Agency Problems
¤ Parent Control of Agency Problems
¤ Corporate Control of Agency Problem
- Ex: Enron and WorldCom
– Alter financial reporting
– Investors: Unaware of financial problems of company

• Sarbanes-Oxley Act, 2002 (SOX)


¤ Transparent process of reporting, productivity & financial
condition of firms.
¤ Implement internal reporting process; easily monitored by
executives & BoD.
¤ Reduced the likelihood of manipulating the reporting process
& improved its accuracy for investors

A1 - 22
Management Structure of an MNC
• The magnitude of agency costs can vary with the
management style of the MNC.
• A centralized management style reduces agency
costs. However, a decentralized style gives more
control to those managers who are closer to the
subsidiary’s operations and environment.
• Some MNCs attempt to strike a balance - they
allow subsidiary managers to make the key
decisions for their respective operations, but the
decisions are monitored by the parent’s
management.

A1 - 23
A1 - 24
A1 - 25
WHY FIRMS PURSUE
INTERNATIONAL BUSINESS
Three commonly held theories to explain
why firms become motivated to expand
their business internationally are:
 Theory of Comparative Advantage
¤ Specialization by countries can increase
production efficiency.
 Imperfect Markets Theory
¤ The markets for the various resources
used in production are “imperfect.”

A1 - 26
Theories of International Business

 Product Cycle Theory


¤ As a firm matures, it may recognize
additional opportunities outside its home
country.

A1 - 27
Theory of comparative advantage
• A country that specializes in some products may not produce other
products, so trade between countries is essential.
• Comparative advantages allow firms to penetrate in foreign markets.
• MNCs’ business grow due to countries’ untransportable specialized
production… means their comparative advantage.
¤ – Japan and US: technology advantage
¤ – China and Malaysia: advantage in the cost of basic labor.
¤ – Jamaica and Mexico: large producers of agricultural and handmade
goods.
• MNCs like Oracle, Intel, and IBM have grown substantially in foreign
countries due to their technology advantage.
• Many Virgin Islands, 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.
• These islands are better-off using some revenues earned from tourism to
import products than producing it locally. A1 - 28
Imperfect Markets Theory
• If country’s markets are closed to others, then no international business.
• If markets were perfect, so factors of production (like: labor, etc.) were
easily transferable, wherever demanded.
• Such unrestricted mobility of factors equates costs & returns and remove
the comparative cost advantage (rationale for international trade and
investment).
• Real world has imperfect market conditions having immobile factors of
production, reasons are costs and restrictions on such transfers.
• • Like: restrictions on transfer of funds and other resources among
countries.
• • MNCs: the Gap and Nike often capitalize on a foreign country’s
particular resources as imperfect markets provide firms an incentive to
seek out foreign opportunities.

A1 - 29
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 market 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 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.
• Firm may develop strategies to prolong the foreign demand for its
product.
• Good approach is to differentiate the product so that competitors cannot
duplicate it exactly.
A1 - 30
International Product Life Cycle

A1 - 31
International
Business Methods
There are several methods by which firms
can conduct international business.
• International trade is a relatively
conservative approach involving
exporting and/or importing.
¤ The internet facilitates international trade
by enabling firms to advertise and manage
orders through their websites.

A1 - 32
International
Business Methods
• Licensing allows a firm to provide its
technology in exchange for fees or some
other benefits.
• Franchising obligates a firm to provide a
specialized sales or service strategy,
support assistance, and possibly an initial
investment in the franchise in exchange
for periodic fees.

A1 - 33
International
Business Methods
• Firms may also penetrate foreign markets
by engaging in a joint venture (joint
ownership and operation) with firms that
reside in those markets.
• Acquisitions of existing operations in
foreign countries allow firms to quickly
gain control over foreign operations as
well as a share of the foreign market.

A1 - 34
International
Business Methods
• Firms can also penetrate foreign markets
by establishing new foreign subsidiaries.
• In general, any method of conducting
business that requires a direct investment
in foreign operations is referred to as a
direct foreign investment (DFI).
• The optimal international business
method may depend on the characteristics
of the MNC.
A1 - 35
International Opportunities

• Investment opportunities - The marginal


return on projects for an MNC is above
that of a purely domestic firm because of
the expanded opportunity set of possible
projects from which to select.
• Financing opportunities - An MNC is also
able to obtain capital funding at a lower
cost due to its larger opportunity set of
funding sources around the world.
A1 - 36
International Opportunities

• Opportunities in Europe
¤ The Single European Act of 1987.
¤ The removal of the Berlin Wall in 1989.
¤ The inception of the euro in 1999.
• Opportunities in Latin America
¤ The North American Free Trade Agreement
(NAFTA) of 1993.
¤ The General Agreement on Tariffs and
Trade (GATT) accord.
A1 - 37
International Opportunities

• Opportunities in Asia
¤ The reduction of investment restrictions by
many Asian countries during the 1990s.
¤ China’s potential for growth.
¤ The Asian economic crisis in 1997-1998.

A1 - 38
Exposure to International Risk
International business usually increases an
MNC’s exposure to:
 exchange rate movements
¤ Exchange rate fluctuations affect cash
flows and foreign demand.
 foreign economies
¤ Economic conditions affect demand.

 political risk
¤ Political actions affect cash flows.
A1 - 39
Managing for Value

• Like domestic projects, foreign projects


involve an investment decision and a
financing decision.
• When managers make multinational
finance decisions that maximize the
overall present value of future cash flows,
they maximize the firm’s value, and hence
shareholder wealth.

A1 - 40
Valuation Model for an MNC

• Domestic Model
n
E CF$, t 
Value = 
t =1 1 k t

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


the end of period t
n = the number of periods into the future
in which cash flows are received
k = the required rate of return by
investors
A1 - 41
Valuation Model for an MNC
• Valuing International Cash Flows
m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows denominated in currency j
to be received by the U.S. parent at the end of
period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S.
parent company
A1 - 42
Valuation Model for an MNC

• An MNC’s financial decisions include how


much business to conduct in each country
and how much financing to obtain in each
currency.
• Its financial decisions determine its
exposure to the international environment.

A1 - 43
Valuation Model for an MNC
Impact of New International Opportunities
on an MNC’s Value

Exposure to
Foreign Economies Exchange Rate Risk

m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 

Political Risk
A1 - 44
Chapter Review

• Goal of the MNC


¤ Conflicts Against the MNC Goal
¤ Impact of Management Control
¤ Impact of Corporate Control
¤ Constraints Interfering with the MNC’s Goal
• Theories of International Business
¤ Theory of Comparative Advantage
¤ Imperfect Markets Theory
¤ Product Cycle Theory
A1 - 45
Chapter Review

• International Business Methods


¤ International Trade
¤ Licensing
¤ Franchising
¤ Joint Ventures
¤ Acquisitions of Existing Operations
¤ Establishing New Foreign Subsidiaries

A1 - 46
Chapter Review

• International Opportunities
¤ Investment Opportunities
¤ Financing Opportunities
¤ Opportunities in Europe
¤ Opportunities in Latin America
¤ Opportunities in Asia

A1 - 47
Chapter Review

• Exposure to International Risk


¤ Exposure to Exchange Rate Movements
¤ Exposure to Foreign Economies
¤ Exposure to Political Risk
• Managing for Value

A1 - 48
Chapter Review

• Valuation Model for an MNC


¤ Domestic Model
¤ Valuing International Cash Flows
¤ Impact of Financial Management and
International Conditions on Value

A1 - 49

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