Lecture Class_1_basics Of Ifm

Module 1: Basics of International Financial Management

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Overview A.

The concept of MNC

B.

Why Firms go for International Business / Theories of Intl Business

C.

How Firms Engage in International Business / Intl Business Methods

D.

Valuation Model for an MNC

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Multinational Corporations 

A firm that has incorporated on one country and has production and sales operations in other countries



Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets Financing _______ Production ________ Sales



There are about 65,000 MNCs in the world according to world investment report by UN

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Goal of the MNC  The commonly accepted goal of an MNC is to maximize shareholder wealth in countries like US, Canada, UK, Australia, and India. Whereas in countries like Germany and France the focus is on stakeholder wealth creation

 For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem.

 Agency costs are normally larger for MNCs than for purely domestic firms, but can vary with the management style of the MNC (Centralized or Decentralized) 4

Managing the MNC Management and Agency Problems a. Parent Control b. Corporate Control How Sarbanes-Oxley (SOX) Improved MNCs Corporate Governance

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Managing the MNC Common Methods to Improve • • • • •

Control

Forming a centralized database of information Ensuring that all data are reported consistently among subsidiaries Implementing a system that automatically checks data for unusual discrepancies Speeding the process by which all departments and subsidiaries have access to data needed Making executives more accountable for financial statements by personally verifying accuracy

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Why Firms Pursue International Business





Theory of Comparative Advantage - Specialization by countries can increase production efficiency Imperfect Markets Theory - The markets for the various resources (capital / labour) used in production are “imperfect.”



Product Cycle Theory - As a firm matures, it may recognize additional opportunities outside its home country

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International Product Life Cycles

Insert chart page 7 Exhibit 1.2

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C. How Firms Engage in International Business  International Trade - a relatively conservative approach involving exporting and/or importing.

 Licensing - provision of technology (copyrights/patents) in exchange for fees or some other benefits.

 Franchising - provision of a specialized sales or service

strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

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C. How Firms Engage in International Business  Joint Ventures - joint ownership and operation by two or more firms.

 Acquisitions of Existing Operations  Establishing New Foreign Subsidiaries Any method of increasing international business that requires a direct investment in foreign operations normally is referred to as a foreign direct investment (FDI)

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C. Why Firms Engage in International Business Summary of Methods by Risk Franchising and Joint Ventures

Foreign Acquisitions

New Foreign Subsidiaries

LEAST RISK

FDI

MOST RISK Degrees of Risk to MNC 11

International Opportunities Cost-benefit Analysis for Purely Domestic Firms versus MNCs Purely Domestic Firm

Marginal Return on Projects

MNC MNC Purely Domestic Firm

Marginal Cost of Capital

Appropriate Size for Purely Domestic Firm

X

Appropriate Size for MNC

Y

Asset Level of Firm

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International Opportunities Opportunities in Europe  Single European Act of 1987  Removal of the Berlin Wall in 1989  Single currency system (EURO) in 1999 Opportunities in America  North American Free Trade Agreement (NAFTA) of 1993 Opportunities in World Market  General Agreement on Tariffs and Trade (GATT) accord replaced by WTO which became effective from 1995 Opportunities in Asia  Significant growth expected for China and India 13

International Risk for MNCs 

Exposure to Exchange Rate Movements 



Exposure to Foreign Economies 



exchange rate fluctuations affect cash flows and foreign demand

economic conditions affect demand

Exposure to Political Risk 

political actions affect cash flows 14

D.

Valuation Model for an MNC

1. Domestic Model

 [ E ( CF$,t ) ]  V = ∑ t  t =1  (1 = k )  n

  

where 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. 15

D.

Valuation Model for an MNC

m E ( CFj , t ) × E (ER j , t ) n ∑  j =1 Value = ∑  t ( ) 1 + k t =1  

[

]

     

E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period t E (ERj,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 U.S. parent company 16

Impact of International Business on an MNC’s Value Exposure to Foreign Economies

Exchange Rate Risk

m E ( CFj , t ) × E (ER j , t ) n ∑  j =1 Value = ∑  t ( ) 1 + k t =1  

[

Political Risk

]

      17

How International Financial Mangement relate to MNC Valuation Exchange Rate Behavior Background on International Financial Economics & Markets

Long-Term Investment and Financing Decisions

Short-Term Investment and Financing Decisions

Exchange Rate Risk Management

Risk and Return of MNC

Value and Stock Price of MNC