CHAPTER 1

Multinational Financial Management : An Overview

After studying this chapter, you should be able to:

 > Identify the main goal of the MNC and potential

conflicts with that goal> Describe the key theories that justify international

business> Explain the common methods used to conduct

international business

Goal of the MNC

The commonly accepted goal of an MNC is to maximize shareholder wealth. Developing a goal is necessary because all decisions should contribute to its accomplishment. Thus, if the objective were to maximize earnings in the near future, rather than to maximize shareholder wealth, the firm’s policies would be different.

Conflicts with the MNC Goal

It has often been argued that managers of a firm may make decisions that conflict with the firm’s goal to maximize shareholder wealth. For example, a decision to establish a subsidiary in one location for the appeal.

A conflict of goals can always exist – this conflict is referred to as the agency problem

Constraints Interfering with the MNC's Goal

When financial managers of MNCs attempt to maximize their firm's value, they are confronted with various constraints that can be classified as environmental, regulatory, or ethical in nature

Environmental constraints : Each country enforces its own environmental constraints. Some countries may enforce more of these restrictions on a subsidiary whose parent is based in a different country. Building codes, disposal of production, waste materials, and pollution controls are examples of restrictions that force subsidiaries to incur additional costs. Many European countries have recently imposed rougher antipollution laws as a result of severe pollution problems.

Regulatory constraints : Each country also enforces its own regulatory constraints pertaining to taxes, currency convertibility rules, earnings remittance restrictions, and other regulations that can affect cash flows of a subsidiary established there.

 Ethical Constraints : There is no consensus standard of business conduct that applies to all countries. A business practice that is perceived unethical in one country may be totally ethical in another. Example : Bribes, Sexual products in Arab countries.

Theories of International Business The commonly held theories as to why firms become motivated to expand their business internationally are (1) the theory of comparative advantage, (2) the imperfect markets theory, and (3) the product cycle theory. The three theories overlap to a degree and can complement each other in developing a rationale for the evolution of international business.

Theory of Comparative AdvantageMultinational business has generally increased over time. Part of this growth is due to the heightened realization that specialization by countries can increase production efficiency. Some countries, such as Japan and the United States, have a technology advantage, while other countries, such as Jamaica, Mexico, and South Africa, have an advantage in the cost of basic labor. Since these advantages cannot he easily transported, countries tend to use their advantages to specialize in the production of goods that can be produced with relative efficiency. This explains why countries such as Japan and the United States are large producers of computer components, while countries such as Jamaica and Mexico are large producers of agricultural and handmade goods.Specialization in some products may result in no production of other products, so that trade between countries is essential. This is the argument made by the classical theory of comparative advantage. Comparative advantages allow firms to penetrate foreign markets.

Imperfect Markets Theory

Countries differ with respect to resources available for the production of goods - Yet, even with such comparative advantages, the volume of international goods would be limited if all resources could be easily transferred among countries. If markets were perfect, factors of production would be freely transferable and mobile.The unrestricted mobility of factors would create equality in costs and would remove the comparative advantage. However, the real world suffers from imperfect market conditions where factors of production are somewhat immobile. There are costs and often restrictions related to the transfer of Labor and other resources used for production.

Product Cycle Theory 

The product cycle theory is a theory made of few steps that follow each other:1_ Firm creates to product to accommodate local demand2_ Firm exports product to accommodate foreign demand3_ Firm establishes foreign subsidiary to establish presence in foreign country to minimize cost4a_ Firm differentiates product from competitors and/or expands product line in foreign country.4b_ Firm's Foreign business declines as its competitive advantages are eliminated

INTERNATIONAL BUSINESS METHODS

Firms use several methods to conduct international business. The most common methods are these:

International trade Licensing Franchising Point Ventures Acquisitions of existing operations Establishing new foreign

subsidiaries

International TradeInternational 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 (importing). This approach entails minimal risk because the firm does not place of its capital at risk. If the firm experiences a decline in its exporting or importing it can normally reduce or discontinue this part of its business at a low cost.

LicensingLicensing obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names in exchange for fees or some other specified benefits. A good point about Licensing is that no exporting and transferring costs are required but as a disadvantage, the company can not assure quality control.

FranchisingFranchising 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  Joint ventureA joint venture is a venture that is operated by two or more firms.Example Fuji & Xerox.

Acquisitions of Existing OperationsFirms frequently acquire other firms in foreign countries as a means of penetrating foreign markets. For example, SCB acquired American ExpressDisadvantage : Very high capital needed.  Establishing New Foreign SubsidiariesFirms can also penetrate foreign markets by establishing new operation subsidiaries to produce and sell their products. Like a foreign acquisition, this process requires a large investment.

EXPOSURE TO INTERNATIONAL RISK Although international business can reduce an MNC's exposure to its country's economic conditions, it usually increases an MNC's exposure to exchange rate movements, (2) foreign economic conditions, and (3) political changes.

Exposure to Exchange Rate Movements

Most international business results in the exchange of one currency for another to make payment. Since exchange rates fluctuate over time, the cash outflows required to make payments change accordingly. Consequently, the number of units of home currency needed to purchase foreign supplies can change even if the suppliers have not adjusted their prices.

Exposure to Foreign Economies When MNCs enter foreign markets to sell products, the demand for these products is dependent on the economic conditions in those markets. Thus, the cash flows of the MNC are subject to foreign economic conditions. For example, U.S. firms such as DuPont and Nike experienced lower-than-expected cash flows because of weak European economies in the 1992-1993 period and again in the 2000-2001 period.

Exposure to Political RiskWhen MNCs establish subsidiaries in foreign countries, they become exposed to political risk, which arises because the host government or the public may take actions that affect the MNC's cash flows. For example, the host government may impose higher taxes on U.S.-based subsidiaries in retaliation for actions by the U.S government. Exp. Terrorism

Overview of an MNC CASHFLOW

Valuation Model For An MNC

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 many models for valuing an MNC.

Domestic ModelBefore modeling an MNC's value, we should consider the valuation of a purely domestic firm that does not engage in any foreign transactions. The value (V) of a purely domestic Firm in the United States is commonly specified as the present value of its expected cash flows, where the discount rate used reflects the weighted cost of capital and represents the required rate of return by investors:

Where 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. 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 (such as an investment to replace old computers or machinery). The expected cash flows are estimated from knowledge about various existing projects as well as other projects that will be implemented in the future. A firm's decisions about how it should invest Funds to expand its business can affect its future cash flows and therefore can affect the firm's value.

Valuing International Cash FlowsAn MNC's value can be specified in the samee manner as a purely domestic organization. However, consider that the expected cash flows generated by a parent in the period t may be coming from various countries which works in different foreign currencies.