1. International Financial Management
Lecture 1 – Part 1 Overview of Financial Management in Multinational Companies

2. Learning 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.
To explain the opportunities and risks in international operations

3. The Multinational Company
A multinational company (MNC) is defined as one that has operating subsidiaries, branches or affiliates located in foreign countries.
MNCs are usually managed from a global perspective rather than from the perspective of any single country.
The ownership of some MNCs is so dispersed internationally that they are known as transnational corporations.

4. Top 10 non-Financial MNCs (Ranked by Foreign Assets)
Company
Country
Industry/Sector 1
General Electric
USA
Equipment 2 BP UK
Petroleum 3
Toyota Motor Corp
Japan
Motor vehicles 4
Royal Dutch/Shell
Netherlands 5
Exxonmobil Corp US 6
Ford Motor Co. 7
Vodafone
Telecom 8
TotalFinaElf
France 9
Electricite de France
Electricity/Gas 10
Wal-Mart
Retail
Source: World Investment Report

5. Top 10 non-Financial MNCs (Ranked by Number of Host Countries)
Company
Country
Industry/Sector
111
Deutsche Post
Germany
Transport /Storage 98
Royal Dutch/Shell
UK/NL
Petroleum 96
Nestle S A
Switzerland
Food/Beverages 89
Siemens AG
Electrical 88
BASF AG
Chemicals 75
Procter & Gamble
USA
Diversified 74
GlaxoSmithKline UK
Pharmaceuticals 72
Linde
Industrial Trucks 71
Bayer AG 68
Philips Electronics
Netherlands
Source: World Investment Report

6. Why do companies go international?
Generally most companies would go abroad:
To boost revenues
To reduce costs
To avoid political, trade and regulatory barriers
To diversify operations

7. Motives for FDI  Attract new sources of demand.
Establish a subsidiary or acquire a competitor in a new market.
Motives
Means of Achieving Benefit
 Enter profitable markets.
Acquire a competitor that has controlled its local market.
 Exploit monopolistic advantages.
Establish a subsidiary in a market where competitors are unable to produce the identical product.
 React to trade restrictions.
Establish a subsidiary in a market where trade restrictions will adversely affect export volume.
 Diversify internationally.
Establish subsidiaries in markets with different business cycles.

8. Motives for FDI  Use foreign factors of production.
Establish a subsidiary in a market that has lower costs of labor or land. Sell the products elsewhere.
Motives
Means of Achieving Benefit
 Use foreign raw materials.
Establish a subsidiary in a market where raw materials are cheap and accessible. Sell the products in that market and elsewhere.
 Use foreign technology. .
Participate in a joint venture or acquire an existing overseas plant to learn about foreign production processes, so as to improve its own operations.
 React to exchange rate movements.
Establish a subsidiary in a new market where the local currency is weak but is expected to strengthen over time.

9. Benefits of International Diversification
Pompey Co., a UK company, plans to invest in a new project in either China or the U.K.
Characteristics of Proposed Project
If Located in the United Kingdom
If Located in China
Mean expected annual return on investment (after taxes)
0.25 (25%)
Standard deviation of expected returns on investment
0.09
0.11
Correlation of expected annual returns on investment with returns of existing UK business
0.80
0.02

10. Benefits of International Diversification
Suppose that the project will constitute 30% of Pompey’s total funds invested in itself, and that the standard deviation of return on its existing business is
If the new project is located in the UK, the portfolio variance for the overall firm
The standard deviation of the overall firm returns =

11. Benefits of International Diversification
If the new project is located in China, the portfolio variance for the overall firm
Thus, the standard deviation of the overall firm returns = 0.078
Therefore, as a whole, Pompey will generate more stable returns if the new project is located in China

12. Theories of International Business
Why are firms motivated to expand their business internationally?
Theory of Comparative Advantage
Specialization by countries can increase production efficiency.
Imperfect Markets Theory
The markets for the various resources used in production are “imperfect.”
Product Cycle Theory
As a firm matures, it may recognize additional opportunities outside its home country.

13. Theory of Comparative Advantage
A country has an absolute advantage in the production of a good relative to another country if it can produce the good at a lower cost or with higher productivity.
A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost relative to another country
Existence of comparative advantage makes specialization and trade between countries essential

14. The Product Life Cycle
 Firm creates product to accommodate local demand
 Firm exports product to accommodate foreign 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

15. International Business Methods
International trade involves exporting and/or importing.
Licensing allows a firm to provide its technology in exchange for fees or some other benefits.
Franchising obliges a firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment, in exchange for periodic fees.
Firms may also penetrate foreign markets by engaging in a joint venture (joint ownership and operation) with firms that reside in those markets.

16. International Business Methods
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.
Firms can also penetrate foreign markets by establishing new foreign subsidiaries.

17. International Business Methods
Many MNCs use a combination of methods to increase international business.
The optimal method for a firm to penetrate a foreign market is partially dependent on the characteristics of the market.
For example, if the consumers are used to buying products from local firms, then licensing arrangements or joint ventures may be more appropriate.

18. Internationalisation and Financial Decision Making
The international environment introduces new opportunities and challenges.
A larger investment opportunity set is available – The MNC has an expanded opportunity set of possible projects from which to select.
With greater investment opportunities, there is a greater need for investment capital – MNC able to obtain capital funding at a lower cost through access to international markets.
Internationalisation however introduces other tax systems, exchange rates, regulatory environments, and political systems.

19. Internationalisation and Domestic Firms
Purely domestic firms also often have significant international activities:
Import and export of products, components and services
Licensing of foreign firms to conduct their foreign business
Exposure to foreign competition in the domestic market
Indirect exposure to international risks through relationships with customers and suppliers

20. Goal of the MNC
Fundamentally, financial objectives of the firm do not change in a global environment.
They still focus on the commonly accepted goal of maximising shareholder wealth.
For MNCs that wholly own their foreign subsidiaries:
Financial managers throughout the MNC have a single goal of maximising the value of the entire MNC.

21. 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
Subsidiary managers may make decisions that maximize the values of their local subsidiaries.

22. 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.
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.

23. Impact of Corporate Control
Various forms of corporate control can reduce agency costs:
Aligning manager and company incentives using managerial compensation plans - stock options
The threat of hostile takeover
Investor monitoring - shareholder activism
The threat of firing managers

24. Impact of Corporate Control
Some Recent cases of Shareholder Activism
Photo-Me yields to activist investors’ demands
Photo-Me International agreed to the demands of two activist shareholders, for the immediate resignation of its chairman and putting a date on the departure of its chief executive. The two directors had been accused of “operational mismanagement” and “poor governance”. See FT 04/09/2007
Connecticut Retirement Plans and Trust (CPRT) Fund, forced American Electric Power to report on how it is reducing its greenhouse emissions and pushed Walt Disney to split the job of chairman and chief executive.

25. Constraints Interfering with the MNC’s Goal
MNC managers are confronted with various constraints:
environmental constraints
regulatory constraints
regulations governing mergers and acquisitions,
restrictions on foreign ownership of local firms,
changes in taxation
ethical constraints

26. Ethics and the Firm
Should a company reduce its ethical standards to compete internationally?
Foreign companies bribed their way into obtaining $37 billion in overseas commercial contracts over the past year, according to a US Commerce Department report based on information that officials say was gathered largely through electronic eavesdropping.
BAE bosses named as corruption suspects
Senior BAE executives were named yesterday as corruption suspects in a leaked document from the Serious Fraud Office, which has been conducting a long investigation into the firm's international arms deals.
The Guardian, Wednesday January 17, 2007
See also: Ethics are dead. Long live BAE!

27. Ethics and the Firm Daimler fires chiefs as it discloses bribes
DaimlerChrysler has dismissed or suspended several employees after an internal investigation uncovered evidence that its executives paid bribes in Asia, Africa and Eastern Europe. The payments, it said, could violate both German law and the Foreign Corrupt Practices Act in the United States - International Herald Tribune, March 7, 2006
Siemens broadens corruption inquiries
A US unit of Siemens, Siemens Medical Solutions, pleaded guilty in federal court on Thursday to obstruction of justice in a case involving a hospital contract for radiology equipment - FT February

28. Ethics and the Firm Ethical considerations seek to:
reduce litigation and judgment costs
maintain a positive corporate image
build shareholder confidence
gain the loyalty and respect of all stakeholders
The expected result is to positively affect the firm's share price.
A survey by McKinsey & Co (2002) suggests that investors are willing to pay 18% to 27% more for shares of companies that exhibit high corporate governance and ethical standards.

29. Exposure to International Risk
International business usually increases an MNC’s exposure to:
exchange rate movements
foreign economies – economic conditions affect demand
political risk
These factors affect the company’s cash flows and/or cost of capital

30. Exposure to Exchange Rates
The value of $100m in UK pounds

31. Exposure to Exchange Rates
The value of €100m in UK pounds

32. Overview of an MNC’s Cash Flows
Profile A: MNCs Focused on International Trade
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

33. Overview of an MNC’s Cash Flows
Profile B: MNCs Focused on International Trade and International Arrangements
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 Firms
Fees for services provided
Fees for services received
Foreign Firms

34. Overview of an MNC’s Cash Flows
Profile C: MNCs Focused on International Trade, Services and FDI
U.K. Customers
Payments for products
U.K.-based MNC
U.K. 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
Foreign Subsidiaries
Funds remitted back
Investment funds
Foreign Subsidiaries

35. Valuation Model for an MNC
Domestic Model
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

36. Valuation Model for an MNC
Valuing International Cash Flows
E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.K. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to UK pounds at the end of period t
k = the weighted average cost of capital of the MNC

37. Should we or should we not?
Investing in a foreign country has both opportunities and risks
Before investing in a foreign country, the potential benefits must be weighed against the costs and risks associated with that specific country.
In particular, the MNC will want to review the foreign country’s economic growth and other macroeconomic indicators, as well as the political structure and policy issues.