MULTINATIONAL FINANCIAL MANAGEMENT Ram Krishna Khatiwada

WHAT IS YOUR VIEW? A. Why many multinational like Teliasonera, Cocacola, Pepsi, KFC, Uliliver etc. entered in Nepal ? B. SN Power, a multinational power developer, has already running one hydropower generation unit in Nepal and try to start another unit. The planned project has IRR of more than 18% whereas the IRR at developed country has less than 8%. Despite having better return, SN Power is very cautious to invest in Nepal. What may be the reasons?

CHAPTER OBJECTIVES To identify the main goal of the multinational corporation (MNC) and potential conflicts with that goal; To describe the key theories that justify international business; and To explain the common methods used to conduct international business.

Multinational Corporation (MNC)Foreign Exchange Markets Product MarketsSubsidiaries International Financial Markets Dividend Remittance & Financing Exporting & Importing Investing & Financing THE INTERNATIONAL FINANCIAL ENVIRONMENT

GOAL OF THE MNC The commonly accepted goal of an MNC is to maximize shareholder wealth. We will focus on MNCs that wholly own their foreign subsidiaries. Financial managers throughout the MNC have a single goal of maximizing the value of the entire MNC.

CONFLICTS WITH THE MNC GOAL When a corporation’s shareholders differ from its managers, a conflict of goals can exist—the agency problem. Agency costs are normally larger for MNCs than for purely domestic firms, due to:  the difficulty in monitoring distant managers  the different cultures of foreign managers  the sheer size of the larger MNCs, and  the tendency to downplay short-term effects. Subsidiary managers may be tempted to make decisions that maximize the values of their respective subsidiaries.

CONFLICTS WITH THE MNC GOAL

IMPACT OF MANAGEMENT CONTROL 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 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 Capital Expenditures 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 Capital Expenditures at A Inventory and Accounts Receivable Management at A Cash Management at A Financing at A Capital Expenditures at B Inventory and Accounts Receivable Management at B Cash Management at B Financing at B Financial Managers of B

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 parent’s management monitors the decisions. Today, electronic networks make it easier for the parent to monitor the actions and performance of its foreign subsidiaries.

IMPACT OF CORPORATE CONTROL Various forms of corporate control can reduce agency costs:  stock options  hostile takeover threat  investor monitoring

CONSTRAINTS INTERFERING WITH THE MNC’S GOAL MNC managers are confronted with various constraints:  environmental constraints  regulatory constraints  ethical constraints A recent study found that investors assigned a higher value to firms that exhibit high corporate governance standards and are likely to obey ethical constraints.

5-14 MERCANTILE THEORY Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -to export more than it imports  advocates government intervention to achieve a surplus in the balance of trade Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another

5-15 THEORY OF ABSOLUTE ADVANTAGE Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it  countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

5-16 HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice  Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice  South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between

5-17 HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK Without trade  Ghana would produce 10 tons of cocoa and 5 tons of rice  South Korea would produce 10 tons of rice and 2.5 tons of cocoa With specialization and trade  Ghana would produce 20 tons of cocoa  South Korea would produce 20 tons of rice  Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice After trade  Ghana would have 14 tons of cocoa left, and 6 tons of rice  South Korea would have 14 tons of rice left and 6 tons of cocoa If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain

5-18 HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK Absolute Advantage and the Gains from Trade

5-19 THEORY OF COMPARATIVE ADVANTAGE David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home

5-20 HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK? Assume  Ghana is more efficient in the production of both cocoa and rice  in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice  So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two  in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice  so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two

5-21 HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK? With trade  Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice  Ghana will still have 11 tons of cocoa, and 4 additional tons of rice  South Korea still has 6 tons of rice and 4 tons of cocoa  if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain Comparative advantage theory provides a strong rationale for encouraging free trade

5-22 HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK? Comparative Advantage and the Gains from Trade

5-23 PRODUCT LIFE CYCLE THEORY The product life-cycle theory - (Raymond Vernon) - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade  the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products  initially, the product would be produced and sold in the U.S.  as demand grew in other developed countries, U.S. firms would begin to export  demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets

5-24 PRODUCT LIFE CYCLE THEORY U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S. As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price the main competitive weapon Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States If cost pressures were intense, developing countries would acquire a production advantage over advanced countries Production became concentrated in lower-cost foreign locations, and the United States became an importer of the product

5-25 PRODUCT LIFE CYCLE THEORY The Product Life Cycle Theory

2. Firm exports product to accommodate foreign demand 1. Firm creates product to accommodate local demand THE INTERNATIONAL PRODUCT LIFE CYCLE 3. Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs 4a. Firm differentiates product from competitors and/or expands product line in foreign country 4b. Firm’s foreign business declines as its competitive advantages are eliminated or

5-27 DOES THE PRODUCT LIFE CYCLE THEORY HOLD? The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s But, the globalization and integration of the world economy has made this theory less valid today  production today is dispersed globally  products today are introduced in multiple markets simultaneously

5-28 WHAT ARE THE IMPLICATIONS OF TRADE THEORY FOR MANAGERS? 1.Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently  firms that do not, may be at a competitive disadvantage 2.First-mover implications - a first-mover advantage can help a firm dominate global trade in that product 3.Policy implications - firms should work to encourage governmental policies that support free trade  firms should lobby the government to adopt policies that have a favorable impact on each component of the diamond

INTERNATIONAL BUSINESS METHODS (1) 1. International trade involves exporting and/or importing. 2. Licensing allows a firm to provide its technology in exchange for fees or some other benefits. 3. Franchizing obligates a firm to provide a specialized sales or service strategy, support assistance and possibly an initial investment, in exchange for periodic fees.

INTERNATIONAL BUSINESS METHODS (2) 4. Firms may also penetrate foreign markets by engaging in a joint venture (joint ownership and operation) with firms that reside in those markets. 5. 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.

INTERNATIONAL BUSINESS METHODS (3) 6. Firms can also penetrate foreign markets by establishing new foreign subsidiaries. Many MNCs use a combination of methods to increase international business. 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 (1) Investment opportunities  The marginal returns on MNC projects are above those of purely domestic firms since MNCs have expanded opportunity sets of possible projects from which to select. Financing opportunities  MNCs can obtain capital funding at a lower cost due to their larger opportunity set of funding sources around the world.

INTERNATIONAL OPPORTUNITIES (2) Opportunities in Europe  the Single European Act of 1987  the removal of the Berlin Wall in 1989  the inception of the euro in 1999  the expansion of the European Union

INTERNATIONAL OPPORTUNITIES (3) Opportunities in Latin America  the North American Free Trade Agreement (NAFTA) of 1993  the removal of investment restrictions Opportunities in Asia  the removal of investment restrictions  the impact of the Asian crisis in 1997–1998

EXPOSURE TO INTERNATIONAL RISK International business usually increases an MNC’s exposure to: 1. exchange rate movements 2. foreign economies 3. political risk

OVERVIEW OF AN MNC’S CASH FLOWS (1) Profile A: MNCs Focused on International Trade U.S.- based MNC U.S. Customers Payments for products U.S. Businesses Payments for supplies Foreign Importers Payments for exports Foreign Exporters Payments for imports

OVERVIEW OF AN MNC’S CASH FLOWS (2) Profile B:MNCs Focused on International Trade and International Arrangements U.S.- based MNC U.S. Customers Payments for products U.S. Businesses Payments for supplies Foreign Importers Payments for exports Foreign Exporters Payments for imports Foreign Firms Fees for services provided Fees for services received Foreign Firms

OVERVIEW OF AN MNC’S CASH FLOWS (3) Profile C: MNCs Focused on International Trade, International Arrangements, and Direct Foreign Investment U.K.- based MNC U.K. Customers Payments for products U.K. Businesses Payments for supplies Foreign Importers Payments for exports Foreign Exporters Payments for imports Foreign Subsidiaries Funds remitted back Foreign Firms Fees for services provided Fees for services received Foreign Firms Investment funds Foreign Subsidiaries

E (CF $,t )=expected cash flows to be received at the end of period t n=the number of periods into the future in which cash flows are received k=the required rate of return by investors VALUATION MODEL FOR AN MNC (1) Domestic Model

E (CF j,t )=expected cash flows denominated in currency j to be received by the U.S. parent at the end of period t E (ER j,t )=expected exchange rate at which currency j can be converted to dollars at the end of period t k=the weighted average cost of capital of the MNC VALUATION MODEL FOR AN MNC (2) Valuing International Cash Flows

IMPACT OF FINANCIAL MANAGEMENT AND INTERNATIONAL CONDITIONS ON VALUE An MNC will decide how much business to conduct in each country and how much financing to obtain in each currency. The MNC’s financial decisions determine its exposure to the international environment. An MNC can control its degree of exposure to exchange rate effects, economic conditions, and political conditions with its financial management.

ORGANIZATION OF THE TEXT 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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