1 - 1 INTERNATIONAL FINANCE Lecture 3

1 - 2 Overview of Lecture 2 Goal of the multinational corporation (MNC) Key theories (Comparative, Imperfect Markets Theory, Product Cycle Theory) Agency Problem and Agency Costs Centralized vs. Decentralized system The International Product Life Cycle  Local Demand→ Foreign Demand→ F. Subsidiaries→ Differentiates or F. Business Declines

1 - 3 International Financial Management An Overview Lecture 3

1 - 4 Lecture Objectives To explain the common methods used to conduct international business. Provide a model for the valuation of MNC.

1 - 5 How Firms Engage in International Business International trade Licensing Franchising Joint ventures Acquisitions of existing operations Establishing new foreign subsidiaries

1 - 6 International Trade Conservative / Traditional Approach Involves exporting or importing Used by firms to penetrate into markets If the firm faces any decline in importing or exporting, it can reduce or discontinue. Internet facilitates the warehouses.

1 - 7 International Trade Use WebPages Advertise with prices Update the WebPages for changes Importers monitor the changes Accept orders online

1 - 8 Licensing Allows a firm to provide its technology in exchange for fees or some other benefits. Quality assurance is difficult. They may use manufacturers in foreign countries to produce some of their products. This expedites the delivery process. Offers lower cost.

1 - 9 Licensing Copyrights, patents, trade marks or trade names Firms with Brand names Using internet and finding manufacturers Use manufacturers in foreign countries to produce some of their products. Subject to specifications

Franchising Obligates a firm to provide  A specialized sales or service  Support assistance,  Possibly an initial investment, in exchange for periodic fees.  McDonald’s, Pizza Hut, Subway Sandwiches, that are owned and managed by local residents in many foreign countries

Franchising Like licensing, franchising allows firms to penetrate into markets without major investments in foreign countries. Relaxation of barriers has promoted numerous franchising arrangements.

Joint Venture A joint venture is a venture that is jointly owned and operated by two or more firms. For example, General Mills, Inc., joined in a venture with Nestlé, so that the cereals produced by General Mills could be sold through the overseas sales by Nestlé.

Joint Venture Xerox Corp and Fuji Co. (Japan) entered into a joint venture. Allowed Xerox to penetrate in to the Japanese Market Fuji entered into photocopying business. General Motors has ongoing joint ventures in many countries for automobile manufacturers.

Acquisitions 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. Procter & gamble purchased a bleach company in Panama. Subject to the risk of large losses, because of the large investment required

Acquisitions Some firms enter into partial international acquisitions Requires smaller investments Exposed to less risk In that case, firms don’t get full control over foreign operations.

New Foreign Subsidiaries Firms can also penetrate foreign markets by establishing new foreign subsidiaries. Many MNCs use a combination of methods to increase international business. This method is preferred over acquisitions since you get tailored operations as the firm requires.

Direct Foreign Investment (DFI) In general, any method of conducting business that requires a direct investment in foreign operations is referred to as a direct foreign investment (DFI).

International Opportunities Investment opportunities The marginal returns on MNC projects are more than domestic firms since MNCs have expanded opportunity sets of possible projects from which to select.

International Opportunities Financing opportunities MNCs can obtain capital funding at a lower cost due to their larger opportunity set of funding sources around the world.

Investment Opportunities The figure on next slide shows hypothetical investment opportunities for domestic and international firms. Each horizontal step represents the marginal return of the firm. Left to right projects are prioritized on the basis of marginal returns. Firms will opt for those options that produce higher marginal returns.

Marginal Return on Projects Purely Domestic Firm MNC Asset Level of Firm Investment Opportunities International Opportunities Cost-Benefit Evaluation for Purely Domestic Firms versus MNCs Appropriate Size for Purely Domestic Firm Appropriate Size for MNC XY Marginal Cost of Capital Purely Domestic Firm MNC Financing Opportunities

Financing Opportunities The figure shows cost of capital curve for domestic and international firms. The cost of capital increases with asset size. Growth in asset size requires the increased debt that leads to ¤ Increased interest payments ¤ Greater probability of being unable to meet debt obligations ¤ Cost of capital rises to a firm with its volume of assets

Financing Opportunities If Marginal costs exceeds the marginal returns ¤ The firms should not pursue with such project ¤ For domestic firms accept projects up to “point X” ¤ For MNC’s accept projects up to “point Y” After that point the marginal cost of additional projects exceeds the expected benefits.

International Opportunities Opportunities in Europe ¤ The Single European Act of 1987 (uniform regulations removed taxes) ¤ The removal of the Berlin Wall in 1989 (East & West Germany) ¤ The inception of the euro in 1999 (single currency in all over Europe) ¤ The expansion of the European Union (more countries to become members)

International Opportunities Opportunities in Europe ¤ Restrictions on trade will be reduced ¤ Wages are low in some of the member countries ¤ MNC have started their manufacturing plants ¤ Governments in EU are promoting MNCs and are offering reduced taxes with incentives

Overview Common methods to conduct international business International trade, Licensing, Franchising, Joint ventures, Acquisitions of existing operations, Establishing new foreign subsidiaries Investment opportunities Financing opportunities Marginal Returns and Marginal Costs

Source: Adopted from South-Western/Thomson Learning. 2006