International Financial Management

by Jeff Madura

Reference Books

 Eitman, Stonhill and Moffett; Multinational Business

Finance, Addison-Wesley Publishing Company

 Shapiro, A. C., Multinational Financial Management,

Prentice Hall International Edition

 Maximo V. Eng. et al. Global Finance, Harper Collins

College of Publishers
 Contents

1. The International Financial Environment

2. Exchange Rate Behavior

3. Exchange Rate Risk Management

4. Long Term Asset and Liability Management

5. Short Term Asset and Liability Management

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 Part 1
The International Financial Environment

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 Multinational Financial Management: An
1 Overview
Chapter Objectives

 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

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 Goal of the MNC

 The commonly accepted goal of an MNC is to

maximize shareholder wealth.

 We will focus on MNCs that are based in the

United States and that wholly own their foreign
subsidiaries.

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 Managing the MNC

1. Managers are expected to make decisions that

will maximize the stock price.
2. Focus of this text: MNCs whose parents fully
own foreign subsidiaries (U.S. parent is sole
owner of subsidiary.)
3. International Finance decisions are influenced
by other business discipline functions:
• Marketing
• Management
• Accounting and information systems

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 Conflicts Against the MNC Goal

 For corporations with shareholders who differ

from their managers, a conflict of goals can
exist - the agency problem.

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 Agency Costs

1. Definition: Cost of ensuring that managers

maximize shareholder wealth
2. 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.
• Subsidiary value versus overall MNC value

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 Control of Agency Problems

The magnitude of agency costs can vary with the

management style of the MNC.
1. 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.
• 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.
2. Corporate control of agency problems
• Compensation plans, Blockholders and institutional investors
intervention, hostile takeover threat
3. Sarbanes-Oxley Act (SOX)
Ensures a more transparent process for managers to report on the
9 productivity and financial condition of their firm.
 SOX Methods to Improve Reporting

 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

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 Management Structure of MNC

1. Centralized (See Exhibit 1.1a)

Allows managers of the parent to control
foreign subsidiaries and therefore reduce the
power of subsidiary managers
2. Decentralized (See Exhibit 1.1b)
Gives more control to subsidiary managers
who are closer to the subsidiary’s operation
and environment

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 Exhibit 1.1a Management Styles of MNCs

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 Exhibit 1.1b Management Styles of MNCs

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 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.
 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.

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 Constraints Interfering with the MNC’s Goal

 As MNC managers attempt to maximize their

firm’s value, they may be confronted with
various constraints.
• Environmental constraints.
• Regulatory constraints.
• Ethical constraints.

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 Why Firms Pursue International Business

1. Theory of Comparative Advantage: specialization

increases production efficiency.
2. Imperfect Markets Theory: factors of production are
somewhat immobile providing incentive to seek out
foreign opportunities.
3. Product Cycle Theory: as a firm matures, it
recognizes opportunities outside its domestic
market.

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 Exhibit 1.2 International Product Life Cycles

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 How Firms Engage in International Business

1. International trade
2. Licensing
3. Franchising
4. Joint Ventures
5. Acquisitions of existing operations
6. Establishing new foreign subsidiaries

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

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 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

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 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.

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 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.

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 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.

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 Establishing 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.

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 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.

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Degree of International Business by MNCs

Foreign Sales as a % of Total Sales

Foreign Assets as a % of Total Assets
66%
70% 62% 58%
60% 50%
46% 47%
50% 40%
40% 33%
30%
26%
20% 12%
10%
0%
Campbell's Dow IBM Motorola Nike
Soup Chemical
 International Opportunities

 Investment 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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 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 (Germany) in 1989.
• The inception of the euro in 1999.
 Opportunities in Latin America
• The North American Free Trade Agreement (NAFTA) of 1993.
• The General Agreement on Tariffs and Trade (GATT) accord.
 Opportunities in Asia
• Reduction in investment restrictions by many Asian countries during the 1990s.
• China’s potential for growth.
• The Asian economic crisis in 1997-1998.

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International business usually increases an
MNC’s exposure to:
 Exchange Rate Movements
• Exchange rate fluctuations affect cash flows and
foreign demand.
 Foreign Economies
• Economic conditions affect demand.
 Political Risk
• Political actions affect cash flows.
 Exhibit 1.3 Cash Flow Diagrams for MNCs

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 Valuation Model for an MNC:
Domestic Model

  E  CF$,t   
n
V   t 
t 1  1  k  
Where
• V represents present value of expected cash flows
• E(CF$,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.

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 Valuation Model for an MNC:
Multinational Model


E  CF$,t    E  CF j ,t   E  S j ,t  
m

j 1
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.

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 Valuation Model for an MNC
An MNC that uses two or more currencies


E  CF$,t    E  CF j ,t   E  S j ,t  
m

j 1
• Derive an expected dollar cash flow value for each currency
• Combine the cash flows among currencies within a given
period

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 Uncertainty Surrounding MNC Cash Flows

1. 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.
2. Exposure to international political risk – A foreign
government may increase taxes or impose barriers on the
MNC’s subsidiary.
3. 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.

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 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.

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

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 Valuation Model for an MNC

 An 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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