Ch 01 Multinational Financial Management - An Over view (MTM).ppt

Dr. Md Tapan Mahmud
FBS, BUP
CHAPTER 01
MULTINATIONAL FINANCIAL MANAGEMENT:
AN OVERVIEW

CHAPTER LEARNING OBJECTIVES
• To identify the management goal and organizational structure of the MNC.
• To describe the key theories about why MNCs engage in international
business
• To explain the common methods used to conduct international business.
• To provide a model/conceptual framework for valuing the MNC

INTERNATIONAL FINANCIAL
MANAGEMENT
• MNCs engage in international businesses; initially they:
• Export products
• Import supplies
• When they sniff additional opportunities, they may go for:
• Licensing/Franchising
• Acquisition
• Establishing subsidiaries
• Their managers conduct international financial management:
• International investing and financing
• This is influenced by:
• Exchange rate movements, foreign interest rates, labor costs, inflation, demand/supply and other
economic factors

1-1 MANAGING THE MNC
A. How Business Disciplines Are Used to Manage the MNC?
B. Agency Problems
C. Management Structure of an MNC

• Goal of an MNC is to maximize shareholders’ wealth/stock price
• Some publicly traded MNCs outside US may have additional goals:
• Satisfying the respective government, creditors or employees
• Managers of firms must serve shareholders’ interests if they hope to obtain
funding from the investors
• Financial managers throughout the firm (US & foreign countries) has a
common goal of maximizing the entire MNC’s value, rather than the value of a
particular subsidiary

• Various business disciplines are integrated to manage the MNC
• Management – develop strategies, organize resources
• Marketing – seeks to increase consumer awareness, note changes in consumer
preferences
• Accounting – record & report financial/non-financial information
• Finance – investment and financing decisions
• Common finance decision include:
• 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
A. HOW BUSINESS DISCIPLINES ARE USED TO MANAGE THE MNC

• This issue of agency problem can be explained by the Agency Theory
• This theory can be used to explain various issues of all the business disciplines
mentioned earlier
• Without having an essence of this theory, it becomes utterly difficult for a
business student to grasp the dynamism of cross-connected activities:
• Structure of the agency relationship
• Why agency relationship appears?
• Sources of conflict
• Application in business context
• How to minimize this conflict?
B. AGENCY PROBLEMS

Structurer of Agency Relationship
Shareholders (Principal) Management (Agent)
Though Agency Relationship is typically referred to in a business
context, it may prevail in any capacity…

Structure of Agency Relationship
Shareholder (Principal)
Management (Agent)
Information Asymmetry
> The agent knows more than the principals
(Rotten Lemon Theory)
Corporate Reporting

Why Agency Relationship Appears?
Self-dependent Primitive Society
Little Communities
Surplus – Barter Trade
Sole Proprietorship
Partnership
Corporation

Why Agency Relationship Appears?
Dependency
Specialization
Decentralization

Sources of Conflicts
Information Asymmetry
Self Interest
The Rotten-Lemon
Theory

Application in Business Context
• Whenever a manager owns less than 100% of the
firm’s equity, a potential agency problem exists.
• Where there is dependency, there is Agency problem.
• We can see agency relationships everywhere in our
society. (say, between us and the hairdresser).

Application in Business Context
• In theory, managers would agree with shareholders’
wealth maximization.
• However, managers are also concerned with their
personal wealth, job security, fringe benefits, and
lifestyle.
• This would cause managers to act in ways that do not
always benefit the firm shareholders.

How to Minimize this Conflict?
Two ways:
a)Stick
>Monitoring (Agency Cost)
>Market Forces
b)Carrot(Incentives)
> Stock Options
> Golden Handcuffs
> Performance Plans

• Managers of an MNC may make decisions that conflict with the firm’s goal of
maximizing shareholder wealth.
• For example, a decision to establish a subsidiary in one location versus another
may be based on the location’s appeal to a particular manager rather than on
its potential benefits to shareholders.
• A decision to expand a subsidiary may be motivated by a manager’s desire to
receive more compensation (self-interest) rather than to enhance the value of
the MNC.
• This conflict of goals between a firm’s managers and shareholders is often
referred to as the agency problem.
B. AGENCY PROBLEMS – MNC CONTEXT

• Agency cost (monitoring) of MNCs are larger than purely domestic firms:
• Geography – monitoring the managers of distant subsidiaries is more difficult
• Culture – subsidiary mangers are brought up in varied cultures and prioritize
different aspects of business and may have different values compared to the MNC’s
value
• Size – sheer size of large MNCs can create complexities in the monitoring process
B. AGENCY PROBLEMS – MNC CONTEXT
• Complexities/lack of monitoring might lead to substantial losses for MNCs:
• A trader of JP Morgan Chase & Co. made extremely risky trades
• Financial loss: it lost at least $6.2 billion and paid more than $1 billion in fines and penalties
• Source: the bank’s poor internal control failed to provide adequate employee monitoring

• Parent Control:
• Communicating the common goals clearly – maximizing MNC’s value
• Overseeing subsidiaries decision for (MNC’s) goal conformity
• Compensation (incentives) plans for conforming managers – ex: stock options
B. AGENCY PROBLEMS – HOW THIS CAN BE SOLVED?
• Corporate Control:
• Market force – poor decisions reduce firm value leading to takeover/acquisition and
removal of the weak managers
• Institutional investors – they can influence management, complain to the BOD, force
changes, i.e., removing top management/board members

• The degree of agency cost differs according to the MNC’s management style.
• Centralized management :
• It reduces agency cost
• More control on the subsidiary managers, reducing the power of these managers
• Parent’s managers may decide poorly for they are less informed regarding the operational
context
• Decentralized management:
• It incurs higher agency cost
• Subsidiary managers may fail in optimizing the MNC’s overall value
• However, they have more control, since they are close to the context of the operation
• This style could be more effective subject to a proper compensation (incentive) plan tied to
the MNC’s central goal
C. MANAGEMENT STRUCTURE OF AN MNC

CENTRALIZED MULTINATIONAL FINANCIAL
MANAGEMENT
for an MNC with two subsidiaries, A and B
Financial
Managers
of Parent
Capital Expenditures
at A
Inventory and
Accounts
Receivable
Management at A
Cash
Management
at A
Financing at A
at B
Inventory and
Accounts
Receivable
Management at B
Cash
Management
at B
Financing at B

DECENTRALIZED MULTINATIONAL FINANCIAL
MANAGEMENT
for an MNC with two subsidiaries, A and B
Financial
Managers
of A
at A
Inventory and
Accounts
Receivable
Management at A
Cash
Management
at A
Financing at A
at B
Inventory and
Accounts
Receivable
Management at B
Cash
Management
at B
Financing at B
Financial
Managers
of B

1-2 WHY MNCS PURSUE INTERNATIONAL BUSINESS?
Three common theories to explain the motivation for MNCs expansion are:
A. Theory of Comparative Advantage
B. Imperfect Markets Theory
C. Product Cycle Theory
These theories overlap to some extent and can complement one another while
understanding the evolution of international business practices.

• Specialization by countries can increase production efficiency and constitute
comparative advantage(s) – Advantage can’t easily be transported
• Japan, USA – technological advantage: Oracle, Intel, IBM, Microsoft, Sony, NEC,
Canon, etc.
• China, Malaysia, Bangladesh, India, Vietnam – cost of basic labor: Garments
• Jamaica, Mexico, Brazil – agricultural, handmade goods
• Virgin Island, Sri Lanka - tourism
• Comparative advantage allows firms to penetrate foreign markets
• Overall, it is efficient for a country to capitalize on a specialized arena and to cover
other arenas from the outcome of the specialization
1-2 WHY DO MNCS PURSUE INTERNATIONAL BUSINESS?
A. THEORY OF COMPARATIVE ADVANTAGE

• In a perfect market, factors of production are supposed to be easily
transferrable and can be made available wherever there is a demand
• However, in a real world, market is imperfect, and factors of productions are
somewhat immobile
• Cost and fund restrictions often hampers the mobility of resources – this gap
motivates the MNCs to capitalize on a foreign country’s particular resources:
• North Fest capitalizes on the cheap labor of Bangladesh and make garments here
B. IMPERFECT MARKETS THEORY

• Product Cycle:
1. A firm first becomes established in its home country – information of market and
competition is more readily available
2. When product/service is perceived as superior than the home-products of foreign
consumers, then it starts to export
3. When the product becomes very popular it may start producing the product in
foreign country to reduce its transportation cost
• Differentiating the product from already available ones is the key to prolong foreign
market presence
• Facebook started in USA, expanded in all over the world
• More than 85% of Facebook users are outside USA, allowing it to collect revenue
from the foreign countries
C. PRODUCT CYCLE THEORY

C. PRODUCT CYCLE THEORY
 Firm exports
product to
accommodate
foreign demand.
 Firm creates
product to
accommodate
local demand.
 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

1-3 METHODS TO CONDUCT INTERNATIONAL BUSINESS
A. International Trade
B. Licensing
C. Franchising
D. Joint Ventures
E. Acquisition of Existing Operations
F. Establishment of New Foreign Subsidiaries

INTERNATIONAL OPPORTUNITIES – MOTIVATIONS FOR
INTERNATIONAL BUSINESSES
• 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.

A. INTERNATIONAL TRADE
• It’s a conservative approach
• Export (to penetrate markets) and Import (obtaining supplies at low cost)
• Minimal risk: no capital at risk and can discontinue at low cost
• Boeing, DowDupont, General Electric, IBM: $4 Billion+ annual export sales

B. LICENSING
• One firm provides technology in exchange for fees or other
considerations:
• copyright
• patents
• trademarks
• tradenames
• Software firm allow foreign companies to use their software for a fee:
• They can generate revenue without establishing any production plant
• Without transporting goods to foreign countries

C. FRANCHISING
• Franchisor firm provides- sales/service strategy, support assistance, initial
investment
• It allows local residents to own and manage
• Franchisee must follow standards set by the franchisor while operating
• Franchisor (MNC) often invests directly – Direct Foreign Investment (DFI)
• Mcdonald’s purchases land and establish building and allow the franchisee to
operate for a specified number of years

D. JOINT VENTURES
• Jointly owned and operated by two firms; firms Join to:
• Capitalize the already established markets
• To utilize the comparative advantage of one another
• It requires DFI – both parties contribute to the investment process
• Xerox Corp. and Fuji Co. joined together:
• Xerox wanted to penetrate the Japanese market
• Fuji wanted to enter the photocopying business

E. ACQUISITION OF EXISTING OPERATION
• Motivation to acquire:
• To penetrate foreign markets and to have full control over the foreign business
• MNCs directly invests (DFI) in a foreign country by purchasing the operation
• Acquisition is risky:
• Requires large investment, prone to large losses, difficult to sell a poor firm
• Some firms engage in partial international acquisition just to have a stake:
• It requires smaller investment limiting the potential loss
• Firm will not have complete control over foreign operations

F. ESTABLISHMENT OF NEW FOREIGN SUBSIDIARIES
• Establishing new operation from scratch in foreign countries
• It requires a large DFI like foreign acquisition
• Operations can be tailored according to the firm’s requirement
• Needs long time to reap the benefits:
• Firm will not reap any rewards until a solid customer base is established

CASH FLOW DIAGRAM

1-4 VALUATION MODEL FOR AN MNC
• Background
• Maximizing firm’s value translates into maximizing shareholders’ wealth
• IFM should also be connected to the goal of increasing the MNC’s value
A. Domestic Valuation Model
B. Multinational Valuation Model
C. Uncertainty Surrounding an MNC’s Cash Flows
D. How Uncertainty Affects the MNC’s Cost of Capital

• Before modelling an MNC’s value, lets understand the valuation of a purely
DOMESTIC firm; it doesn’t engage in any foreign transaction
• Dollar Cash Flows
• (Funds received by the firm) – (funds to pay expenses/taxes or to reinvest)
• Expected cash flows are estimated from current knowledge of the existing project
and other potential projects
• Investment decisions impact future cash flow and in turn firm’s value
• Increase in expected cash flows should increase the value of a firm
A. DOMESTIC VALUATION MODEL

• Cost of Capital:
• (RRR) Required Rate of Return = Cost of capital (Cost of Debt + Cost of Equity)
• Cost of Capital = (WACC) Weighted Average Cost of Capital of all the firm’s projects
• Credit rating has a negative correlation with the Cost of Capital/RRR
• RRR has a negative correlation with the firm’s value
• More RRR means the expected future cash flows will be discounted at a higher
interest rate and vice versa

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

• Background
• Equation idea is the same as a purely domestic firm
• Expected cash flows here might come from various countries and are exposed to
various foreign currencies
• Each expected cash flow stream of foreign currency are converted into dollars (home
currency)
• All the converted cash flows are the added together to have the expected cash flows
B. MULTINATIONAL VALUATION MODEL
     
 




m
j
t
j
t
j
t S
E
CF
E
CF
E
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.

• Dollar Cash Flows of an MNC that uses two (2) currencies
     
 




m
j
t
j
t
j
t S
E
CF
E
CF
E
1
,
,
$,
 Derive an expected dollar cash flow value for each currency
 Combine the cash flows among currencies within a given period

• Dollar Cash Flows of an MNC that uses multiple currencies
• Process is the same as the last equation used for two currencies

• Valuation of an MNC’s Cash Flows Over Multiple Periods
• Use the single period equation to all future periods to have estimated dollar cash
flows
• Discount the estimated dollar cash flows for each period using WACC
• Add these cash flows to estimate the VALUE of the MNC
• Caution – To avoid double counting, any expected cash flow received by a foreign
subsidiaries should not be counted in the valuation model unless they are remitted
to the parents

• MNC’s future cash flows are subject to both the domestic and international
issues:
• Economic condition
• Political condition
• Exchange rate risk
• Exposure to International Economic Conditions
• Cash flow from a foreign country depends on the consumer demand
• Consumer demand is influenced by national income
• Better economic condition increases national income and more employment, which
in turn impact consumer demand
• Conversely, declining international economic condition can negatively affect MNC’s
C. UNCERTAINTY SURROUNDING AN MNC’S CASH FLOWS

Exposure to
international economic
Condition

• Exposure to International Political Risk
• A foreign government may increase taxes or impose barriers on the MNC’s
subsidiary
• A foreign country may boycott the MNC and vice versa due to various frictions
• Frictions: governmental organization, policies (tax rules), financial condition

• Exposure to Exchange Rate Risk
• If foreign currency weakens against USD, MNC will receive a lower dollar cash flow

• More uncertainty related to an MNC’s future cash flows leads to a higher
expected rate of return
• It increase the MNC’s cost of obtaining capital and lowers its valuation
D. HOW UNCERTAINTY AFFECTS THE MNC’S COST OF CAPITAL

• 17 – International Joint Venture
• 19 – Valuation of an MNC (licensing, acquisition, export, discontinuation)
• 20 – Assessing motives for international business (theory of competitive
advantage, imperfect market theory, product cycle theory, exchange rate risk,
political risk)
• 22 – Impact of international business on cash flow and risk
• 29 – Exposure of MNCs to exchange rate movements
• 32 – MNC cash flow and exchange rate risk
• 33 – Estimating an MNCs cash flow
• 34 – Uncertainty surrounding an MNC’s cash flow
• 36 – Impact of Uncertainty on MNC’s valuation
• 37 – Exposure of MNC’s cash flow
• Case: Blade Inc.
EXERCISE/PROBLEM GUIDE

Ch 01 Multinational Financial Management - An Over view (MTM).ppt

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