Introduction to International

Financial Management
Chapter 1:

International
Financial
Management:
An Overview
Multinational Corporations (MNCs)

• MNCs are defined as firms that engage

in some form of international business.

• Their managers conduct international

financial management.
 Goal of the MNC

• The commonly accepted goal of an MNC is

to maximize shareholder wealth
(measured by share price).
• Functions of Financial Management
¤ Acquisition of funds: generating funds
(internally or externally) at a lowest
possible cost
¤ Investment of funds: invest funds in such
a way that increases wealth
 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 scattering of distant subsidiaries—difficult
to monitor
¤ The culture of foreign managers may be
different and they may not follow uniform goals
¤ Subsidiary value (e.g. serve local employees’
welfare) versus overall MNC value.
¤ The sheer size of the MNC.
 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.
• A decentralized style gives more control to
those managers who are closer to the
subsidiary’s operations and environment.
Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
 Impact of Management Control

• 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.
 Impact of Management Control

• Electronic networks make it easier for the

parent to monitor the actions and
performance of foreign subsidiaries.
• For example, corporate intranet or internet
email facilitates communication. Financial
reports and other documents can be sent
electronically too.
 Impact of Corporate Control

• Various forms of corporate control can

reduce agency costs.
¤ Stock compensation (e.g. options to buy
stocks) for board members and executives.
¤ The threat of a hostile takeover—new
shareholders can remove the old managers
¤ Monitoring and intervention by large
shareholders (e.g. mutual funds or pension
funds).
 Theories of International Business
Why are firms motivated to expand
their business internationally?
❶ Theory of Comparative Advantage
¤ Specialization by countries can increase
production efficiency.
¤ E.g. USA and Japan have technological
advantages; Bangladesh, India, China have
advantage on basic labor resources.
¤ Specialization and Gains from Trade—country
having comparative advantage in making a good
would be able to produce it at a lower
(opportunity) cost.
 Theories of International Business
❷ Imperfect Markets Theory
¤ The markets for the various resources
used in production are “imperfect.”—
factors of production are immobile (e.g.
labor cannot freely move, land is immobile)
¤ Many foreign firms established their
production units in countries where the
cost of labor and land are cheaper.
 Theories of International Business
❸ Product Cycle Theory
¤ As a firm matures, it may recognize
additional opportunities outside its home
country.
 Methods to Conduct
International Business

There are several methods by which firms

can conduct international business.
• International Trade
• Licensing
• Franchising
• Joint Venture
• Acquisition of existing operations
• Establishment of new foreign subsidiaries
• 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).
• This approach entails minimal risk
because the firm does not place any of its
capital at risk exporting and/or importing.
• The internet facilitates international trade
by enabling firms to advertise and
manage orders through their websites.
• Licensing allows a firm to provide its
technology (e.g. copyrights, patents,
trademarks) in exchange for fees or some
other benefits. Licensing allows firms to
use their technology in foreign markets
without major investment in foreign
countries.

• The major disadvantage in licensing is

that it is often difficult to control the
quality of the product/service.
• 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, allowing local residents
to own and manage the units.
• A joint venture is a venture that is jointly
owned and operated by two or more firms.

• A firm can penetrate foreign markets by

engaging in a joint venture with firms that
reside in foreign 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. Usually, poor
performers sell their existing businesses to
others. It is relatively (compare to
developing own subsidiary) a cheaper
option to penetrate foreign market.
• Firms can also penetrate foreign markets
by establishing new foreign subsidiaries.
It requires a large investment.

• In general, any method of conducting

business that requires a direct investment
in foreign operations is referred to as a
direct foreign investment (DFI).
Cash Flow Diagram for MNCs
 Factors Unique to MNCs

• Exchange rate
• Multiple inflation rates
• International differences in tax rates
• Multiple money markets
• Currency controls
• Multiple political situations
 Risks as Advantages!!!
• Taking advantages by MNCs (Being a large
global firm)
¤ Ability to mobile people, money and material
¤ Access segmented capital and money markets
¤ Economic/political differences---International
diversification opportunities
¤ Information updates continuously --- in relation to
technical/research advancement of its
competitors
¤ Higher bargaining power while negotiating with
foreign governments---due to its sheer size!!!
 Valuation Model for an MNC

• Domestic Model

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 (WACC)
 Valuation Model for an MNC
• Valuing International Cash Flows

CFj,t represents the amount of cash flow denominated in a

particular foreign currency j at the end of period t
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.
Valuation Model for an MNC That
Uses 2 Currencies
 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 international

• Economic conditions
• Political conditions &
• Exchange rate risk
 Uncertainty Surrounding an MNC’s
Cash Flows: Economic Conditions
An MNC can be adversely affected by its exposure to international
economic 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.

EXAMPLE: 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.”
 Uncertainty Surrounding an MNC’s
Cash Flows: Political Conditions
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.

EXAMPLE: Recently, (in 2022) PepsiCo, Coca-Cola, McDonald’s and

Starbucks each said they are suspending business in Russia after that
country’s invasion of Ukraine. It’s a symbolic move by the iconic U.S.
brands, some of which have been operating in the country since it was
part of the Soviet Union. In recent days, all four companies have
drawn criticism for continuing to operate in Russia while other U.S.
companies announced business suspensions.
Uncertainty Surrounding an MNC’s
Cash Flows: 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.
How MNCs Valuation is Exposed
to Uncertainty (Risk)
How Chapters Relate to Valuation