Managing Finance in Foreign Subsidiaries:

An Overview
 Learning Objectives
 To identify the main goal of the multinational corporation
(MNC) and potential conflicts with that goal;
 To describe the key theories that justify international
business;
 To explain the common methods used to conduct
international business; and
 Understand risk exposure associated with international
business
 Multinational Corporations’ Goals
• Multinational Corporations (MNCs) are defined as firms that engage
in some form of international business.

• The commonly accepted goal of an MNC is to maximize shareholder

wealth.

• We will focus on MNCs that wholly own their foreign subsidiaries.

Financial managers throughout the MNC have a

single goal of maximizing the value of the entire
MNC and therefore serve the shareholders.
How business Disciplines are used to
Manage the MNC
 Business Disciplines to Manage
MNCs
• Management is used to develop strategies to motivate and control
employees who work in an MNC and to organise the resources in a
manner that 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, which can be
used to report financial information to investors.
 Business Disciplines to Manage
MNCs
• Finance is used to make investment and financing decisions for the
MNC. Common finance decisions include:

– Whether to discontinue operations in a specific country

– Whether to pursue new business in a particular country

– Whether to expand business in a particular country

– How to finance expansion in a particular country.

• These finance decisions for each MNC are partially influenced by the
other business discipline functions.
Agency Problems with MNCs Goal
 Conflicts with the MNC Goal
• When a corporation’s shareholders’ interests differ from that of its
managers, a conflict of goals can exist—the agency problem.

• Agency costs are normally larger for MNCs than for purely domestic
firms, due to:

– the difficulty in monitoring distant managers in foreign countries

– the different cultures of foreign subsidiary managers,

– the sheer size of the larger MNCs, and

– the tendency to downplay short-term effects. This can be a challenge,

especially, in countries where some people may perceive the priority of
corporations should be to serve the workers.
Agency Problem resulting from Subsidiary
Managers
 Conflicts with the MNC Goal
• Subsidiary managers may be tempted to make
decisions that maximize the values of their
respective subsidiaries.
Management Control of the subsidiary by the
parent company
 Control Measures
• Parent control of Agency Problems:

– The parent corporation of an MNC may be able to prevent agency problems

with proper governance.

– It should clearly communicate the goals of each subsidiary to ensure that all
subsidiaries focus on maximizing the value of the MNC rather than their
respective values.

– The parent can oversee the subsidiary decisions to check whether the
subsidiary managers are satisfying the MNC’s goals.

– The parent can also implement compensation plans that reward the subsidiary
managers stock (or options to buy stock as a fixed price)
 Control Measures
• Corporate control of Agency Problems:

– Various forms of corporate control can also help prevent these agency
problems.

– For instance, if the MNC’s managers make decisions that reduce its value,
another firm may be able to acquire the MNC at a low price and will probably
remove weak managers.

– In addition, institutional investors such as pension funds or mutual funds that

have large holdings of an MNC’s stock have some influence over management
because they can complain to the board of directors if poor decisions are made
by managers.
 Control Measures
• Improvement in internal control process:
– 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 all subsidiaries have
access to the data that they need

• Making executives more accountable for financial statements by personally

verifying their accuracy.
Management Structure of an MNC
 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 and it is
more likely to result in agency problems.
 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
 Management Structure of an MNC
• Given the obvious tradeoff between centralized and decentralized
management styles, some MNCs attempt to achieve the advantages
of both styles.

• That is, they allow subsidiary managers to make the key decisions
about their respective operations, but the parent’s management
monitors the decisions to ensure that they are in best interests of the
entire MNC.

• The Internet is making it easier for the parent to monitor the actions
and performance of foreign subsidiaries of an MNC.
Constraints to MNC’s Goals
Constraints Interfering with the MNC’s
Goal
• MNC managers are confronted with various
constraints:

– environmental constraints
– regulatory constraints
– ethical constraints

 A recent study found that investors assigned a

higher value to firms that exhibit high corporate
governance standards and are likely to obey
ethical constraints.
Why Firms Pursue International Business
 International Business: Theories

Why are firms motivated to expand their

business internationally?
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.”
 International Business: Theories

Why are firms motivated to expand their

business internationally?
Product Cycle Theory
– As a firm matures, it may recognize additional
opportunities outside its home country.
 The International Product Life Cycle

 Firm creates product  Firm exports product to

to accommodate local accommodate foreign  Firm
demand demand establishes
foreign subsidiary
to establish
presence in
foreign country
and possibly to
a. Firm differentiates reduce costs
or
product from competitors
and/or expands product b. Firm’s foreign
line in foreign country business declines as its
competitive advantages
are eliminated
How Firms Engage in International Business
 International
Business Methods
 International trade involves exporting (penetrate markets) and/or
importing (to obtain supplies at low cost )

 Licensing allows a firm to provide its technology (copyright, patents,

trademarks or trade names) in exchange for fees or some other benefits.

 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.

 Franchising obligates a firm to provide a specialized sales or service

strategy, support assistance, and possibly an initial investment, in exchange
for periodic fees. For example, KFC
 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.

 An acquisition of an existing corporation is subject to the risk of large losses. if

the foreign operations perform poorly, it may be difficult to sell the operations
at a reasonable price.

 This requires a smaller investment than full international acquisitions and

therefore exposes the fi rm to less risk.
 International
Business Methods
Firms can also penetrate foreign markets by
establishing new foreign subsidiaries.

Establishing new subsidiaries may be preferred to

foreign acquisitions 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.
Direct Foreign Investment (DFI)
 Foreign Direct
Investment
• Many MNCs use a combination of methods to increase international
business.
 In general, any method of conducting business that requires a
direct investment in foreign operations is referred to as a direct
foreign investment (DFI).
• International trade and licensing usually are not considered to be DFI
because they do not involve direct investment in foreign operations.

• Franchising and joint ventures tend to require some investment in

foreign operations, but to a limited degree.
 Foreign Direct
Investment
• Foreign acquisitions and the establishment of new foreign
subsidiaries require substantial investment in foreign operations and
represent the largest portion of DFI.

• Many MNCs use a combination of methods to increase international

business.

• For instance, IBM and PepsiCo, have substantial direct foreign

investment but also derive some of their foreign revenue from
various licensing agreements.
International Opportunities to MNCs
 International Opportunities
• Investment opportunities

– The marginal returns on MNC projects are above those of purely

domestic firms since MNCs have expanded opportunity sets of
possible projects from which to select.

• Financing opportunities

– MNCs can obtain capital funding at a lower cost due to their

larger opportunity set of funding sources around the world.
 International Opportunities
Cost-Benefit Evaluation for
Purely Domestic Firms versus MNCs

Purely
Investment
Domestic
Opportunities MNC
Marginal Firm
Return on
Projects MNC
Purely
Marginal Domestic
Cost of Firm
Capital
Financing Appropriate Size
Opportunities for Purely Appropriate Size
Domestic Firm for MNC

X Y Asset Level
of Firm
 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
– the expansion of the European Union
 International Opportunities
• Opportunities in Latin America
– the North American Free Trade Agreement (NAFTA)
of 1993
– the removal of investment restrictions
• Opportunities in Asia
– the removal of investment restrictions
– the impact of the Asian crisis in 1997-1998

Opportunities in Africa
(ECOWAS common external tarriff)
Cash Flow for MNCs
 MNC’s Cash Flows: An Overview

Profile A: MNCs Focused on International Trade

Cash Inflows from Exporting Foreign Importers

MNC
Cash Outflows to Pay for Importing
Foreign Exporters
 MNC’s Cash Flows: An Overview
Profile B: Licensing, Franchising, Joint Ventures by MNC

Cash Inflows from Services Provided Foreign Firms or

Government Agencies
Cash outflows from Services Received

MNC
 MNC’s Cash Flows: An Overview
Profile C: Investment in Foreign Subsidiaries by the MNC

Funds remitted back Foreign Subsidiaries

Investment funds Foreign Subsidiaries

MNC
Valuation Model for an MNC
 International Opportunities
• The value of an MNC is relevant to its shareholders and its
debtholders.

• When managers make decisions that maximize the value of the firm,
they maximize shareholder wealth.

• There are numerous methods of valuing an MNC, and some methods

will lead to the same valuation.

• However, before modeling an MNC’s value, we need to consider the

valuation of a purely domestic firm that does not engage in any
foreign transactions.
 MNC Valuation Model
• 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

NOTE
Expected cash flows in period t represent
funds received by the firm minus funds needed to pay
 MNC Valuation Model
Multinational Model

Where CFj,t represents the amount of cash flows denominated in a particular foreign
currency j at the end of period t, and 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.
 MNC Valuation Model
Valuation of an MNC That Uses Two Currencies
• An MNC that does business in two currencies could measure its expected
dollar cash flows in any period by multiplying the expected cash flow in each
currency times the expected exchange rate at which that currency could be
converted to dollars and then summing those two products.

• For example: Carolina Co. has expected cash flows of $100,000 from local
business and 1 million Ghanaian Cedis from business in Ghana at the end of
period t. Assuming that the cedi’s value is expected to be $0.22 when
converted into dollars, what is the expected dollar cash flows.

• Note that the same formula applies to valuation of MNC that Uses Multiple
Currencies.
 MNC Valuation Model
Valuing an MNC that Uses Multiple Currencies
Steps
• Estimate the amount of cash flows that the firm will receive at the end of
the period in each currency

• 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 currencies

• Multiply the amount of each foreign currency to be received by the

forecasted exchange of that currency

• Add the estimated cash flows for all currencies in order to determine the
total expected cash flows in the period.
 MNC Valuation Model
• Valuing an MNC receiving multiple currencies over multiple periods

 m 
n 

E CF j , t E S 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 (Sj,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
MNC
Uncertainty surrounding an MNC’s Cash
Flows
 International Risk Exposure
• International business usually increases an
MNC’s exposure to:
 International economic conditions
 International political risk
 Exchange Rate Risk
 International Risk Exposure
• Exposure to International Economic Conditions

– The amount of consumption in any country is influenced by the

income earned by consumers in that country.

– If economic conditions weaken,

• the income of consumers becomes relatively low,

• consumer purchases of products decline
• And MNCs sales in that country may be lower than expected.

– This results in a reduction in the MNCs cash flows, and therefore

in its value.
 International Risk Exposure
• Exposure to International Political Risk

– Political risk in any country can affect the level of an MNCs sales.

– A foreign government may increase or impose barriers on the

MNCs subsidiary.

– Alternatively, consumers in a foreign country may boycott the

MNC if there is friction between the government of their country
and the MNCs home country.

– Political actions like these can reduce the cash flows of the MNC.
 International Risk Exposure
• Exposure to Exchange Rate Risk

– If the foreign currencies to be received by an MNC (US-based

MNC) suddenly weaken against the dollar, the MNC will receive a
lower amount of dollar cash flows than was expected.

– MNCs have cash outflows in one or more foreign currencies

because they import supplies and materials from firms in other
countries.

• If these foreign currencies strengthen, the MNC will need a larger amount
of the domestic currency to obtain the foreign currencies.

• This reduces the MNCs domestic currency’s cash flows and thus, reduces
its value.
How Uncertainty (Surrounding its future cash
flows) affects the MNC’s Cost of Capital
 How Uncertainty Affects the MNC’s Cost of Capital
• If there is suddenly more uncertainty surrounding its future cash
flows,

– investors may only be willing to invest in the MNC if they can expect to
receive higher rate of return.

• As a result, the higher level of uncertainty increases the return on

investment required by investors (which reflects an increase in the
MNC’s cost of obtaining capital)

– MNC’s valuation decreases.

Impact of Financial Management and
International Conditions on Value
 Impact of Financial Management and International
Conditions on Value
• An MNC will decide how much business to conduct in each
country and how much financing to obtain in each
currency.

• The MNC’s financial decisions determine its exposure to

the international environment.

 An MNC can control its degree of exposure to exchange rate effects,

economic conditions, and political conditions with its financial
management.