International Finance #5

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International Financial Management 13th Edition

by Jeff Madura

1Multinational Financial Management: An Overview

 Identify the management goal and organizational structure of the Multinational Corporation (MNC).

 Describe the key theories that justify international business.

 Explain the common methods used to conduct international business.

 Provide a model for valuing the MNC.

Chapter Objectives

Managing the MNC (1 of 4)

Managers are expected to make decisions that will maximize the stock price.

Focus of this text: MNCs whose parents fully own foreign subsidiaries (U.S. parent is sole owner of subsidiary).

Managing the MNC (2 of 4)

How Business Disciplines Are Used to Manage 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  How to finance expansion in a particular country

 Finance decisions are influenced by other business discipline functions:  Marketing  Management  Accounting and information systems

Managing the MNC (3 of 4)

Agency Problems  The conflict of goals between managers and shareholders  Agency Costs  Definition: Cost of ensuring that managers maximize shareholder

wealth.  Costs are normally higher for MNCs than for purely domestic

firms for several reasons:  Monitoring managers of distant subsidiaries in foreign countries is

more difficult.  Foreign subsidiary managers raised in different cultures may not

follow uniform goals.  Sheer size of larger MNCs can create large agency problems.  Some non-U.S. managers tend to downplay the short-term effects

of decisions.

Managing the MNC (4 of 4)

Agency Problems (cont.)  Parent control of agency problems  Parent should clearly communicate the goals for each subsidiary

to ensure managers focus on maximizing the value of the subsidiary.

 Corporate control of agency problems  Entire management of the MNC must be focused on

maximizing shareholder wealth.  Sarbanes-Oxley Act (SOX)  Ensures a more transparent process for managers to report on

the productivity and financial condition of their firm.

SOX Methods to Improve Reporting

Agency Problems (cont.)  How SOX Improved Corporate Governance of MNCs  Establishing a centralized database of information  Ensuring that all data are reported consistently among

subsidiaries  Implementing a system that automatically checks for unusual

discrepancies relative to norms  Speeding the process by which all departments and subsidiaries

have access to all the data they need  Making executives more accountable for financial statements

Management Structure of MNC

Management Structure of MNC  Centralized (See Exhibit 1.1a)

 Allows managers of the parent to control foreign subsidiaries and therefore reduce the power of subsidiary managers.

 Decentralized (See Exhibit 1.1b)  Gives more control to subsidiary managers who are closer to

the subsidiary’s operation and environment.  How the Internet Facilitates Management Control

 Makes it easier for parent to monitor the actions and performance of its foreign subsidiaries.

Exhibit 1.1a Management Styles of MNCs

Exhibit 1.1b Management Styles of MNCs

Why MNCs Pursue International Business

Theory of Competitive Advantage: Specialization increases production efficiency.

Imperfect Markets Theory: Factors of production are somewhat immobile, providing incentive to seek out foreign opportunities.

Product Cycle Theory: As a firm matures, it recognizes opportunities outside its domestic market. (Exhibit 1.2)

Exhibit 1.2 International Product Life Cycles

How Firms Engage in International Business (1 of 8)

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

How Firms Engage in International Business (2 of 8)

International Trade

 Relatively conservative approach that can be used by firms to:

 penetrate markets (by exporting).

 obtain supplies at a low cost (by importing).

 Minimal risk — no capital at risk

 How the Internet Facilitates International Trade

 The internet facilitates international trade by allowing firms to advertise their products and accept orders on their websites.

How Firms Engage in International Business (3 of 8)

Licensing

 Obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names) in exchange for fees or some other specified benefits.

 Allows firms to use their technology in foreign markets without a major investment and without transportation costs that result from exporting.

 Major disadvantage: difficult to ensure quality control in foreign production process

How Firms Engage in International Business (4 of 8)

Franchising  Obligates firm to provide a specialized sales or service strategy,

support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

 Allows penetration into foreign markets without a major investment in foreign countries.

Joint Ventures  A venture that is jointly owned and operated by two or more

firms. A firm may enter the foreign market by engaging in a joint venture with firms that reside in those markets.

 Allows two firms to apply their respective cooperative advantages in a given project.

How Firms Engage in International Business (5 of 8)

Acquisitions of Existing Operations  Acquisitions of firms in foreign countries allows firms to have

full control over their foreign businesses and to quickly obtain a large portion of foreign market share.

 Subject to the risk of large losses because of larger investment.

 Liquidation may be difficult if the foreign subsidiary performs poorly.

How Firms Engage in International Business (6 of 8)

Establishment of New Foreign Subsidiaries

 Firms can penetrate markets by establishing new operations in foreign countries.

 Requires a large investment.

 Acquiring new as opposed to buying existing allows operations to be tailored exactly to the firms needs.

 May require smaller investment than buying existing firm.

How Firms Engage in International Business (7 of 8)

Summary of Methods

 Any method of increasing international business that requires a direct investment in foreign operations is referred to as direct foreign investment (DFI).

 International trade and licensing usually not included.

 Foreign acquisition and establishment of new foreign subsidiaries represent the largest portion of DFI.

How Firms Engage in International Business (8 of 8)

Summary of Methods (cont.)  Exhibit 1.3 Cash Flow Diagrams for MNCs

 The first diagram reflects an MNC that engages in international trade. International cash flows result from paying for imports or receiving cash flow from exports.

 The second diagram reflects an MNC that engages in some international arrangements. Outflows include expenses such as expenses incurred from transferring technology or funding partial investment in a franchise or joint venture. Inflows are receipts from fees.

 The third diagram reflects an MNC that engages in direct foreign investment. Cash flows exist between the parent company and the foreign subsidiary.

Exhibit 1.3 Cash Flow Diagrams for MNCs

Valuation Model for an MNC (1 of 6)

Where  V represents present value of expected cash flows  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.

( )[ ] ( )∑

=   

  

+ =

t t t

k CFE

V 1

Domestic Model

Valuation Model for an MNC (2 of 6)

Domestic Model (cont.)  Dollar Cash Flows

 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.

 Cost of Capital  The required rate of return (k) in the denominator of the

valuation equation.  A weighted average of the cost of capital based on all the firms

projects.

Valuation Model for an MNC (3 of 6)

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

particular foreign currency j at the end of period t,

 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.

( ) ( ) ( )[ ]∑ =

×= m

j tjtjt SECFECFE

1 ,,$,

Multinational Modell

Valuation Model for an MNC (4 of 6)

Multinational Model (cont.)  Valuation of an MNC that uses two currencies

 Could measure its expected dollar cash flows in any period by multiplying the expected cash flow in each currency by the expected exchange rate at which that currency would be converted to dollars and then summing those two products.

 Valuation of an MNC that uses multiple currencies

 Derive an expected dollar cash flow value for each currency  Combine the cash flows among currencies within a given period

( ) ( ) ( )[ ]∑ =

×= m

j tjtjt SECFECFE

1 ,,$,

Valuation Model for an MNC (5 of 6)

Multinational Model (cont.)  Valuation of an MNC’s cash flows over multiple periods

 Apply single period process to all future periods  Discount the estimated total dollar cash flow for each period at

the weighted cost of capital

( ) ( )[ ] ( )∑

∑ =

× =

j tjtj

SECFE V

1 2

1 ,,

Valuation Model for an MNC (6 of 6)

Uncertainty Surrounding MNC Cash Flows (Exhibit 1.4)  Exposure to international economic conditions — If

economic conditions in a foreign country weaken, purchase of products decline and MNC sales in that country may be lower than expected. (Exhibit 1.5)

 Exposure to international political risk — A foreign government may increase taxes or impose barriers on the MNC’s subsidiary.

 Exposure to exchange rate risk — If foreign currencies related to the MNC subsidiary weaken against the U.S. dollar, the MNC will receive a lower amount of dollar cash flows than was expected.

Summary of International Effects (Exhibit 1.4)

Exhibit 1.4 How an MNC’s Valuation is Exposed to Uncertainty

Exhibit 1.5 Potential Effects of International Economic Conditions

How Uncertainty Affects the MNC’s cost of Capital

How Uncertainty Affects the MNC’s cost of Capital  A higher level of uncertainty increases the return on

investment required by investors and the MNC’s valuation decreases.

Organization of the Text (Exhibit 1.6)

Chapters 2-8 discuss international markets and conditions from a macroeconomic perspective focusing on external forces that can affect the value of an MNC Chapters 9-21 take a microeconomic perspective and focus on how the financial management of an MNC can affect its value

Exhibit 1.6 Organization of Chapters

Summary (1 of 4)

 The main goal of an MNC is to maximize shareholder wealth. When managers are tempted to serve their own interests instead of those of shareholders, an agency problem exists. MNCs tend to experience greater agency problems than do domestic firms. Proper incentives and communication from the parent may help to ensure that subsidiary managers focus on serving the overall MNC.

Summary (2 of 4)

International business is justified by three key theories.  The theory of comparative advantage suggests that each

country should use its comparative advantage to specialize in its production and rely on other countries to meet other needs.

 The imperfect markets theory suggests that because of imperfect markets, factors of production are immobile, which encourages countries to specialize based on the resources they have.

 The product cycle theory suggests that after firms are established in their home countries, they commonly expand their product specialization in foreign countries.

Summary (3 of 4)

 The most common methods by which firms conduct international business are international trade, licensing, franchising, joint ventures, acquisitions of foreign firms, and formation of foreign subsidiaries. Methods such as licensing and franchising involve little capital investment but distribute some of the profits to other parties. The acquisition of foreign firms and formation of foreign subsidiaries require substantial capital investments but offer the potential for large returns.

Summary (4 of 4)

 The valuation model of an MNC shows that the MNC’s value is favorably affected when its expected foreign cash inflows increase, the currencies denominating those cash inflows increase, or the MNC’s required rate of return decreases. Conversely, the MNC’s value is adversely affected when its expected foreign cash inflows decrease, the values of currencies denominating those cash flows decrease (assuming that they have net cash inflows in foreign currencies), or the MNC’s required rate of return increases.

Slide Number 1
1
Managing the MNC (1 of 4)
Managing the MNC (2 of 4)
Managing the MNC (3 of 4)
Managing the MNC (4 of 4)
SOX Methods to Improve Reporting
Management Structure of MNC
Exhibit 1.1a Management Styles of MNCs
Exhibit 1.1b Management Styles of MNCs
Why MNCs Pursue International Business
Exhibit 1.2 International Product Life Cycles
How Firms Engage in International Business (1 of 8)
How Firms Engage in International Business (2 of 8)
How Firms Engage in International Business (3 of 8)
How Firms Engage in International Business (4 of 8)
How Firms Engage in International Business (5 of 8)
How Firms Engage in International Business (6 of 8)
How Firms Engage in International Business (7 of 8)
How Firms Engage in International Business (8 of 8)
Exhibit 1.3 Cash Flow Diagrams for MNCs
Valuation Model for an MNC (1 of 6)
Valuation Model for an MNC (2 of 6)
Valuation Model for an MNC (3 of 6)
Valuation Model for an MNC (4 of 6)
Valuation Model for an MNC (5 of 6)
Valuation Model for an MNC (6 of 6)
Exhibit 1.4 How an MNC’s Valuation is Exposed to Uncertainty
Exhibit 1.5 Potential Effects of International Economic Conditions
How Uncertainty Affects the MNC’s cost of Capital
Organization of the Text (Exhibit 1.6)
Exhibit 1.6 Organization of Chapters
Summary (1 of 4)
Summary (2 of 4)
Summary (3 of 4)
Summary (4 of 4)