International Financial Management

11th Edition
by Jeff Madura

Chapter One

Dr. Marwa El Maghawry

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 Multinational Financial Management: An
1 Overview
Chapter Objectives

 Describe the key theories that justify international

business
 Identify the management goal and organizational
structure of the Multinational Corporation (MNC).
 Explain the common methods used to conduct
international business
 Provide a model for valuing the MNC

2
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 Why Firms Pursue International Business

1. Theory of Competitive 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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Theory of Competitive Advantage

Multinational 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 Korea, have
an advantage in the cost of basic labor.

Since these advantages cannot be 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

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Imperfect Markets Theory

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.

There may also be restrictions on transferring funds and other

resources among countries. Because markets for the various
resources used in production are “imperfect,” MNCs such as
Gap and Nike often capitalize on a foreign country’s resources.

Imperfect markets provide an incentive for firms to seek out

foreign opportunities

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Product Cycle Theory

After a firm is establishing itself in its home country. It will

accommodate foreign demand for the firm’s product first by
exporting. Then, the firm may feel the only way to retain its
advantage over competition in foreign countries is to produce the
product in foreign markets, thereby reducing its transportation
costs.

Whether the firm’s foreign business diminishes or expands over

time will depend on how successful it is at maintaining some
advantage over its competition.

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 Exhibit 1.1 International Product Life Cycles

7
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 What is meant by Multinational Corporations (MNCs)?

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 that are
intended to maximize the value of the MNC.

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

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 Management Structure of MNC

1. Centralized (See Exhibit 1.2a)

Allows managers of the parent to control
foreign subsidiaries and therefore reduce the
power of subsidiary managers
2. Decentralized (See Exhibit 1.2b)
Gives more control to subsidiary managers
who are closer to the subsidiary’s operation
and environment

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 Exhibit 1.2a Management Styles of MNCs

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 Exhibit 1.2b Management Styles of MNCs

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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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 Exhibit 1.3 Cash Flow Diagrams for MNCs

20
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 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.

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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.

22
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 Valuation Model for an MNC:
Multinational Model

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

23
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 Valuation Model for an MNC
An MNC that uses two or more currencies

m
E CF$,t    E CF j ,t E S j ,t   
j 1
 Derive an expected dollar cash flow value for each currency
 Combine the cash flows among currencies within a given
period

24
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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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 Agency Problems

The conflict of goals between managers and

shareholders

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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.
 Some forgein managers tend to downplay the short-term
effects of decisions.
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 Control of Agency Problems

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.
2. Corporate control of agency problems
Entire management of the MNC must be focused on maximizing
shareholder wealth.
3. Sarbanes-Oxley Act (SOX)
Ensures a more transparent process for managers to report on the
productivity and financial condition of their firm.

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 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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 Summary

 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.

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 Summary

International business is justified by three key theories.

1. 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.
2. 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.
3. The product cycle theory suggests that after firms are
established in their home countries, they commonly
expand their product specialization in foreign countries.

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 Summary

 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.

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 Summary

 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.

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