INS3032 Chap 1

International Financial Management
13th Edition
by Jeff Madura
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
1 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1 Multinational Financial Management: An 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.
2 © 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1-3
Goal of Financial Management
What should be the goal of a corporation?

Survive
Avoid financial distress and bankruptcy
Beat the competition
Maximize profits?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s
stock?
Does this mean we should do anything and

everything to maximize owner wealth?
1.1 Finance and the Firm (4 of 10)
 What Is the Goal of the Firm?
 Maximize Shareholder Wealth
The primary goal of managers should be to maximize
the wealth of the firm’s owners
In most instances this is equivalent to maximizing the
stock price
 Maximize Profit?
Does profit maximization lead to the highest possible
share price?
For at least three reasons, the answer is often no:
 Timing
 Cash Flows
 Risk
The Goal of the Firm
 The goal of the firm is to create value for the firm’s owners
(that is, its shareholders). Thus the goal of the firm is to
“maximize shareholder wealth” by maximizing the price of
the existing common stock.
 Good financial decisions will increase stock price, and poor
financial decisions will lead to a decline in stock price.
Managing the MNC (1 of 4)
Managers are expected to make decisions that will

maximize the stock price.
Focus of this text: MNCs whose parents fully own

foreign subsidiaries (U.S. parent is sole owner of
subsidiary).
How Business Disciplines Are Used to Manage the

MNC
• Common finance decisions include:
• Whether to discontinue operations in a particular country
• 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
• Finance decisions are influenced by other business discipline
functions:
• Marketing
• Management
• Accounting and information systems
Agency Problems
• The conflict of goals between managers and shareholders
• https://www.youtube.com/watch?v=kd2r3ARB2tk
• Who is agent?
• Who is principal in the video?
• What is the conflict between them?
• What is the reason under the conflict?
Agency Problems
• The conflict of goals between managers and shareholders
• Agency Costs
• Definition: Cost of ensuring that managers maximize shareholder
wealth.
• 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 non-U.S. managers tend to downplay the short-term
effects of decisions.
Agency Problems (cont.)

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

• How SOX Improved Corporate Governance of MNCs
• 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
Management Structure of MNC
Management Structure of MNC

• Centralized (See Exhibit 1.1a)
• Allows managers of the parent to control foreign subsidiaries
and therefore reduce the power of subsidiary managers.
• Decentralized (See Exhibit 1.1b)
• Gives more control to subsidiary managers who are closer to
the subsidiary’s operation and environment.
• How the Internet Facilitates Management Control
• Makes it easier for parent to monitor the actions and
performance of its foreign subsidiaries.
Exhibit 1.1a Management Styles of MNCs
Exhibit 1.1b Management Styles of MNCs
10-minute discussion
- Take some examples for decentralized and

centralized MNCs
- Which management style can reduce agency
cost?
- You can use your company as a typical example
Why MNCs Pursue International Business
Theory of Competitive Advantage: Specialization

increases production efficiency.
Imperfect Markets Theory: Factors of production are
somewhat immobile, providing incentive to seek out
foreign opportunities.
Product Cycle Theory: As a firm matures, it recognizes
opportunities outside its domestic market. (Exhibit 1.2)
How to produce a Barbie doll
- Designed in
California
- With parts and
clothing from Japan,
China, Hong Kong,
Malaysia, Indonesia,
Korea, Italy and
Taiwan
- Assembled in
Mexico
- and sold in 144
countries
Why MNCs Pursue International Business
Imperfect Markets Theory: Factors of production are

somewhat immobile, providing incentive to seek out
foreign opportunities.
If each country’s markets were closed to all other countries,
then there would be no international business.
At the other extreme, if markets were perfect and thus the
factors of production (such as labor) easily transferable, then
labor and other resources would flow wherever they were in
demand.
Examples, please!!!
Market Imperfections
 Legal restrictions on the movement of goods, people, and

capital
 Transactions costs
 Shipping costs
 Tax arbitrage
 Information asymmetry: one party does not know enough
information about the other party to make accurate
decisions.
Exhibit 1.2 International Product Life Cycles
How Firms Engage in International Business (1 of 8)
International Trade
Licensing
Franchising
Joint Ventures
Acquisitions of Existing Operations
Establishment of New Foreign Subsidiaries
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

• How the Internet Facilitates International Trade
• The internet facilitates international trade by allowing firms
to advertise their products and accept orders on their
websites.
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
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.
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.
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.
Establishment of 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.
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.
Summary of Methods (cont.)

• 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.
Exhibit 1.3 Cash Flow Diagrams for MNCs
Valuation Model for an MNC (1 of 6)
Domestic Model
V  
  E CF$,t  
 n
   

t 1  1  k 
t
Where
 
• V represents present value of expected cash flows
• E(CF$,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.
Domestic Model (cont.)

• Dollar Cash Flows
• The dollar cash flows in period t represent funds received
by the firm minus funds needed to pay expenses or taxes
or to reinvest in the firm.
• Cost of Capital
• The required rate of return (k) in the denominator of the
valuation equation.
• A weighted average of the cost of capital based on all the
firms projects.
Multinational Modell
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.
Multinational Model (cont.)

• Valuation of an MNC that uses two currencies
• Could measure its expected dollar cash flows in any period
by multiplying the expected cash flow in each currency by
the expected exchange rate at which that currency would be
converted to dollars and then summing those two products.
• Valuation of an MNC that uses multiple 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
Multinational Model (cont.)

• Valuation of an MNC’s cash flows over multiple periods
• Apply single period process to all future periods
• Discount the estimated total dollar cash flow for each
period at the weighted cost of capital
 E CF  E S 
m
n j ,t j ,t
V 
j 1
t 1 1  k  2
Uncertainty Surrounding MNC Cash Flows (Exhibit 1.4)

• 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. (Exhibit 1.5)
• Exposure to international political risk — A foreign
government may increase taxes or impose barriers on the
MNC’s subsidiary.
• 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.
Summary of International Effects (Exhibit 1.4)
Exhibit 1.4 How an MNC’s Valuation is Exposed to
Uncertainty
Exhibit 1.5 Potential Effects of International Economic
Conditions
Foreign Exchange Risk
 This is risk that foreign currency profits may evaporate in

dollar terms due to unanticipated unfavorable exchange
rate movements.
 Suppose $1 = ¥100 and you buy 10 shares of Toyota at
¥10,000 per share. One year later the investment is worth
ten percent more in yen: ¥110,000.
 But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.
 Can you explain why you lost money?
How Uncertainty Affects the MNC’s cost of Capital
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.
Organization of the Text (Exhibit 1.6)
Chapters 2-8 discuss international markets and

conditions from a macroeconomic perspective focusing
on external forces that can affect the value of an MNC
Chapters 9-21 take a microeconomic perspective and
focus on how the financial management of an MNC can
affect its value
Exhibit 1.6 Organization of Chapters
Summary (1 of 4)
• 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.
Summary (2 of 4)
International business is justified by three key theories.

• 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.
• 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.
• The product cycle theory suggests that after firms are
established in their home countries, they commonly
expand their product specialization in foreign countries.
Summary (3 of 4)
• 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.
Summary (4 of 4)
• 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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International Financial Management

• Identify the management goal and organizational

What should be the goal of a corporation?

Does this mean we should do anything and

Managers are expected to make decisions that will

Focus of this text: MNCs whose parents fully own

How Business Disciplines Are Used to Manage the

Agency Problems (cont.)

Agency Problems (cont.)

Management Structure of MNC

- Take some examples for decentralized and

Theory of Competitive Advantage: Specialization

Imperfect Markets Theory: Factors of production are

 Legal restrictions on the movement of goods, people, and

• Minimal risk — no capital at risk

Acquisitions of Existing Operations

Establishment of New Foreign Subsidiaries

Summary of Methods (cont.)

Domestic Model (cont.)

• Sj,t represents the exchange rate at which the foreign

Multinational Model (cont.)

• Derive an expected dollar cash flow value for each currency

Multinational Model (cont.)

Uncertainty Surrounding MNC Cash Flows (Exhibit 1.4)

 This is risk that foreign currency profits may evaporate in

How Uncertainty Affects the MNC’s cost of Capital

Chapters 2-8 discuss international markets and

• The main goal of an MNC is to maximize shareholder

International business is justified by three key theories.

• The most common methods by which firms conduct

• The valuation model of an MNC shows that the MNC’s

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