InternationalFinancial Management

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Jeff Madura10th Edition

Prepared By: Hamad Raza (Lecturer GCUF)

Chapter 1:

Multinational Financial Management:An Overview

What is Finance?

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Finance can be defined as the art and science of managing the money.

Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments.

DEFINITION OF INTERNATIONAL FINANCE

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International finance is the branch of economics that studies the dynamics of foreign exchange (where money in one currency is exchanged for another), foreign direct investment (Foreign direct investment (FDI) is investment directly into production in a country by a company located in another country,) and how these affect international trade.

It also includes the study of international projects, international investments and the international capital flows.

International Finance can be broadly defined, as the study of the financial decisions taken by a multinational corporation in the area of international business i.e. global corporate finance.

DEFINITION OF INTERNATIONAL FINANCE MANAGEMENT

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International Financial Management is a managerial activity which is concerned with the planning and controlling of financial resources of a firm involved in international business.

REASONS TO STUDY INTERNATIONAL FINANCE MANAGEMENT

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To understand the global economyTo understand the effect of Global Finance

on businessGlobal finance has become increasingly

important as it serves world trade and foreign investment.

To make intelligent decisions

CLASSIFICATION OF INTERNATIONAL BUSINESS OPERATIONS

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The international business firms are broadly divided into three categories:

(a)International Firm(b)Multinational firm(c)Transnational Firm(a) International Firm The traditional activity of an international firm involves

importing and exporting. Goods are produced in the domestic market and then exported to foreign buyers.

Financial management problems of this basic international trade activity focus on the payment process between the foreign buyer (seller) and domestic seller (buyer).

CLASSIFICATION OF INTERNATIONAL BUSINESS OPERATIONS

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(b) Multinational firm As international business expands, the firm needs to be closer to

the consumer, closer to cheaper sources of inputs, or closer to other producers of the same product gain from their activities. It needs to produce abroad as well as sell abroad.

As the domestic firm expands its operations across borders, incorporating activities in other countries, it is classified as a multinational firm.

(c)Transnational Firm As the multinational firm expands its branches, affiliates,

subsidiaries, and network of suppliers, consumers, distributors and all others, which fall under the firm umbrella of activities, the once traditional home country becomes less and less well defined.

Firms like Unilever, Phillips, Ford, and Sony have become intricate network with home offices defined differently for products, processes, capitalization and even taxation.

Multinational Corporations

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Multinational corporations (MNCs) are defined as

firms that engage in some form of international business.

Their managers conduct international financial management, which involves international investing and financing decisions those are intended to maximize the value of the MNC.

The goal of their managers is to maximize the value of the firm, which is similar to the goal of managers employed by domestic companies.

Goal of the MNC

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The commonly accepted goal of an MNC is to maximize shareholders wealth.

This book is focused on MNCs those are based in the United States and wholly own their foreign subsidiaries.

Conflicts Against the MNC Goal

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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.The sheer size of the MNC.The culture of foreign managers.Subsidiary value versus overall MNC value.

Impact of Management Control

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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.

Centralized Multinational Financial Management

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For a MNC with two subsidiaries, A and B

FinancialManagersof Parent

Capital Expendituresat A

Inventory andAccountsReceivableManagement at A

CashManagementat A

Financing at A

Capital Expendituresat B

Inventory andAccountsReceivableManagement at B

CashManagementat B

Financing at B

Decentralized Multinational Financial Management

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For a MNC with two subsidiaries, A and B

FinancialManagersof A

Capital Expendituresat A

Inventory andAccountsReceivableManagement at A

CashManagementat A

Financing at A

Capital Expendituresat B

Inventory andAccountsReceivableManagement at B

CashManagementat B

Financing at B

FinancialManagersof B

Corporate Control of Agency Problem

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Various forms of corporate control can reduce agency costs & therefore ensure that managers make decisions to satisfy the MNC’s shareholders.

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.

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.

Constraints Interfering with the MNC’s Goal

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As MNC managers attempt to maximize their firm’s value, they may be confronted with various constraints.Environmental constraints.Regulatory constraints.Ethical constraints.

Theories of International Business

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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.”Product Cycle Theory:

As a firm matures, it may recognize additional opportunities outside its home country.

Firm exports product to accommodate foreign demand.

Firm creates product to accommodate local demand.

The International Product Life Cycle

Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

a. Firm differentiates product from competitors and/or expands product line in foreign country.

b. Firm’s foreign business declines as its competitive advantages are eliminated.

or

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InternationalBusiness Methods

International trade is a relatively conservative approach involving exporting and/or importing.The internet facilitates international trade by

enabling firms to advertise and manage orders through their websites.

There are several methods by which firms can conduct international business.

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InternationalBusiness MethodsLicensing allows a firm to provide its

technology in exchange for fees or some other benefits.

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.

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InternationalBusiness 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.

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InternationalBusiness 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 optimal international business method may depend on the characteristics of the MNC.

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Degree of International Business by MNCs

26%

62%58%

33%

47%

12%

46%40%

50%

66%

0%

10%

20%

30%

40%

50%

60%

70%

Campbell's Soup IBM Nike

Foreign Sales as a % of Total Sales

Foreign Assets as a % of Total Assets

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International OpportunitiesInvestment 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.

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Marginal Return on

Projects

Purely Domestic Firm

MNC

Asset Levelof Firm

InvestmentOpportunities

International OpportunitiesCost-benefit Evaluation for Purely Domestic Firms versus MNCs

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

X Y

Marginal Cost of Capital

Purely Domestic Firm MNC

FinancingOpportunities

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Exposure to International Risk

exchange rate movementsExchange rate fluctuations affect cash flows

and foreign demand. foreign economies

Economic conditions affect demand. political risk

Political actions affect cash flows.

International business usually increases an MNC’s exposure to:

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Managing for ValueLike 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.

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n

ttt

k1=

$,

1

CF E = Value

E (CF$,t ) = expected cash flows to be received at the end of period tn = the number of periods into the future in which cash flows are receivedk = the required rate of return by investors

Valuation Model for an MNC

Domestic Model

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n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = the weighted average cost of capital of the U.S. parent company

Valuation Model for an MNCValuing International Cash Flows

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Valuation Model for an MNCAn 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.

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Valuation Model for an MNC

Impact of New International Opportunities on an MNC’s Value

Exchange Rate Risk

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

Political Risk

Exposure toForeign Economies

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How Chapters Relate to Valuation

Background on International Financial Markets (Chapters 2-5)

Exchange Rate Behavior (Chapters 6-8)

Long-Term Investment and Financing Decisions (Chapters 13-18)

Short-Term Investment and Financing Decisions (Chapters 19-21)

Exchange Rate Risk Management (Chapters 9-12)

Risk and Return of MNC

Value and Stock Price of MNC

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Chapter ReviewGoal of the MNC

Conflicts Against the MNC GoalImpact of Management ControlImpact of Corporate Control Constraints Interfering with the MNC’s Goal

Theories of International BusinessTheory of Comparative AdvantageImperfect Markets TheoryProduct Cycle Theory

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Chapter ReviewInternational Business Methods:

International TradeLicensingFranchisingJoint VenturesAcquisitions of Existing OperationsEstablishing New Foreign Subsidiaries

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Chapter ReviewExposure to International Risk

Exposure to Exchange Rate MovementsExposure to Foreign EconomiesExposure to Political Risk

Managing for Value

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Chapter ReviewValuation Model for an MNC

Domestic ModelValuing International Cash FlowsImpact of Financial Management and

International Conditions on ValueHow Chapters Relate to Valuation

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