Chapter 1

International
Financial Management: An Overview
 Chapter Objectives

• To identify the main goal of the

multinational corporation (MNC) and
conflicts with that goal;
• To describe the key theories that justify
international business; and
• To explain the common methods used to
conduct international business.
International Business Finance
 Multinational Financial Management: Financial
management of MNCs.
 MNCs are firms that engage in some form of
international business.
 International business: producing and/or selling
goods in foreign countries.
 Import of goods, service exports, imports,
purchases/sale of financial assets from/in foreign
countries etc be included to make the definition to
be more accurate.
 Goal of the MNC
 Like the goal of domestic firms’ financial
management, the commonly accepted goal
of an MNC or international financial
management is to maximize shareholder
wealth.
 How do we maximize shareholder wealth?
 Cash flow considerations
 Risk and cost of capital considerations
 Exchange rate considerations
 Valuation 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 firm is commonly specified as
the present value of its expected cash
flows.
• Domestic Model V 
n
E (CF $, t )
t 1 (1  K ) t

• An MNC Model n
E (CFj, t ) * E ( ERj, t )
V 
t 1 (1  K ) t
Conflicts Against the MNC Goal
• For corporations with shareholders who differ from
their managers, a conflict of goals can exist - the
agency problem.
• Agency costs are normally larger for MNCs than for
purely domestic firms.
¤ The sheer size of the MNC.
¤ The scattering of distant subsidiaries.
­ Distant subsidiary’s managers are difficult to
monitor.
¤ The culture of foreign managers. Due to cultural
differences, they may not follow uniform goals.
 Impact of Management Control
• The magnitude of agency costs can vary with the
management style of the MNC.
• A centralized management style reduces agency
costs. However, a decentralized mgt style can be
more effective if the foreign subsidiary mgrs
recognize the goal of maximizing the value of the
MNC.
• 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.
Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Cash

Management Managers Management
at A of Parent at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Financial Cash

Management Managers Managers Management
at A of A of B at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
 Impact of Corporate Control
• Various forms of corporate control can
reduce agency costs.
¤ Stock compensation for board members
and executives
¤ options to buy stock
¤ The threat of a hostile takeover if the MNC
is inefficiently managed.
¤ Monitoring and intervention by large
shareholders. Example: pension funds
­ These institutions might hold a large
proportion of MNC’s outstanding stocks
 Constraints
Interfering with the MNC’s Goal
• As MNC managers attempt to maximize their
firm’s value, they may be confronted with various
constraints.
¤ Environmental constraints.
­ Eg. Polution control- many European countries
have tougher anti-polution laws which
increases cost of the MNC
¤ Regulatory constraints.
­ Earning remittance restrictions
­ Regulations pertaining to taxes
¤ Ethical constraints.
Theories of International Business
Why are firms motivated to expand
their business internationally?
 Theory of Comparative Advantage: A comparative
advantage occurs when a country can produce a
good/service at a lower opportunity cost than another
country.
• Practical Example: Comparative Advantage
• Consider two countries (France and the United States) that
use labor as an input to produce two goods: wine and cloth.
• In France, one hour of a worker’s labor can produce either 5
cloths or 10 wines.
• In the US, one hour of a worker’s labor can produce either 20
cloths or 20 wines.
­ Which country should import & export which commodity?
Theories of International Business
 Imperfect Markets Theory
¤ Different countries have different resources
¤ However, the markets for the various resources
used in production are “imperfect.”
­ Not freely transferable
­ Has cost
­ There is restriction
¤ If markets were perfect, would there be
comparative advantage?
¤ Therefore, because markets are imperfect, firms
want to capitalize on a foreign country’s resources
Theories of International Business
Why are firms motivated to expand their
business internationally?
 Product Cycle Theory
¤ Information about markets and competition is
more easily available at home country than foreign
country.
­ Thus, a firm is initially established in its home
country.
¤ When a firm expands and is able to more than
accommodate local demand, it starts exporting.
¤ As time passes, the firm will establish a foreign
subsidiary to reduce its transportation costs
 The International Product Life Cycle

 Firm creates  Firm exports

product to product to  Firm
accommodate accommodate establishes
local demand. foreign demand. foreign
subsidiary
to establish
presence in
a. Firm or foreign
differentiates b. Firm’s country
product from foreign and
competitors business possibly to
and/or expands declines as its reduce
product line in competitive costs.
foreign country. advantages are
eliminated.
 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.
¤ Minimal risk because capital is not placed
at risk.
¤ The internet facilitates international trade
by enabling firms to advertise and manage
orders through their websites.
 International Business Methods
• Licensing allows a firm to provide its technology
(copyrights, patents, trademarks or trade names)
in exchange for fees or some other benefits.
¤ Licensing allows firms to use their technology in
foreign markets without a major investment in
foreign countries and without the transportation
costs that result from exporting.
¤ A license is an authorization (by the licensor) to
use the licensed material (by the licensee).
¤ Example: software license.
 International Business Methods
• 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.
¤ It is the practice of using another firm’s successful
business model .
¤ Like licensing, franchising allows firms to
penetrate foreign markets without a major
investment in foreign countries.
¤ Two important payments:1) a royalty for the trade-
mark and 2) reimbursement for the training &
advisory services.
¤ Example: McDonald’s corporation- hamburger fast
food restaurant. Another is Coca cola company
¤ Quality control is essential here since it may cause
disappointment of customers.
 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.
¤ Helps for firms to apply their comparative
advantage
• 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.
¤ Acquire other firms in foreign countries.
 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 largest portion of DFI comes from the latter
two methods since there is substantial direct
investment in foreign operations.
 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.
 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.
Overview of an MNC’s Cash Flows

Profile A: MNCs focused on International Trade

Payments for products U.S. Customers

U.S.- Payments for supplies U.S. Businesses
based
MNC Payments for exports Foreign Importers
Payments for imports Foreign Exporters
Overview of an MNC’s Cash Flows
Profile B: MNCs focused on International Trade and
International Arrangements

Payments for products U.S. Customers

Payments for supplies U.S. Businesses
U.S.-
based Payments for exports Foreign Importers
MNC Payments for imports Foreign Exporters
Fees for services
Foreign Firms
Costs of services
 Overview of an MNC’s Cash Flows
Profile C: MNCs focused on International Trade, International
Arrangements, and Direct Foreign Investment
Payments for products
U.S. Customers
Payments for supplies
U.S. Businesses

U.S.- Payments for exports

Foreign Importers
based Payments for imports
MNC Foreign Exporters
Fees for services
Foreign Firms
Costs of services
Funds remitted
Foreign Subsidiaries
Funds invested
 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.
 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
 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
 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.