Chapter 1 - Multinational Financial MGMT - Overview

Question 1

Managers are expected to make decisions that will:

Answer 1

maximize the shareholder wealth/stock price.

Question 2

Common finance decisions include:

Answer 2

1. Whether to pursue new business in a particular country
2. Whether to expand business in a particular country
3. How to finance expansion in a particular country
4. Whether to discontinue operations in a particular country

Question 3

Finance decisions are influenced by other business discipline functions such as:

Answer 3

1. Marketing
2. Management
3. Accounting and information systems

Question 4

Agency Problems:

Answer 4

1. The conflict of goals between managers and shareholders
2. Agency Costs

Question 5

Agency Costs Definition:

Answer 5

Cost of ensuring that managers maximize shareholder wealth.

Question 6

Agency Costs are normally higher for MNCs than for purely domestic firms for several reasons:

Answer 6

1. Monitoring managers of distant subsidiaries in foreign countries is more difficult.
2. Foreign subsidiary managers raised in different cultures may not follow uniform goals.
3. Sheer size of larger M N Cs can create large agency problems.

Lack of monitoring can lead to substantial losses for MNCs

Question 7

Agency Problems:

Answer 7

The parent corporation of an MNC would be able to prevent most agency problems with proper governance.

Question 8

Parent control of agency problems:

Answer 8

Parent should clearly communicate the goals for each subsidiary to ensure managers focus on maximizing the value of the MNC rather than that of the subsidiary.

-The parent can oversee subsidiary decisions to check whether each subsidiary’s managers are satisfying the MNC’s goals. The parent also can implement compensation plans that reward those managers who satisfy the MNC’s goals.One commonly used incentive is to provide managers with the MNC’s stock

Question 9

Corporate control of agency problems:

Answer 9

Entire management of the M N C must be focused on maximizing shareholder wealth.

-If managers make poor decisions that reduce the MNC’s value, then another firm might acquire it at this lower price; the new owner would then probably remove the weak managers. Moreover, institutional investors (for example, mutual and pension funds)with large holdings of an MNC’s stock have some influence over management and may complain to the board of directors if managers are making poor decisions. Institutional investors may seek to enact changes, including removal of high-level managers or even board members, in a poorly performing MNC

Question 10

Sarbanes-Oxley Act (S O X):

Answer 10

Ensures a more transparent process for managers to report on the productivity and financial condition of their firm.

Question 11

How S O X Improved Corporate Governance of M N Cs

Answer 11

1. Establishing a centralized database of information
2. Ensuring that all data are reported consistently among subsidiaries
3. Implementing a system that automatically checks for unusual discrepancies relative to norms
4. Speeding the process by which all departments and subsidiaries have access to all the data they need
5. Making executives more accountable for financial statements

-These systems make it easier for a firm’s board members to monitor the financial reporting process. In this way, SOX reduced the likelihood that managers of a firm can manipulate the reporting process and, therefore, improved the accuracy of financial information for existing and prospective investors.

Question 12

Management Structure of M N C: Centralized management style

Answer 12

1. Allows managers of the parent to control foreign subsidiaries and therefore reduce the power of subsidiary managers.
2. Reduce agency costs

Question 13

Management Structure of M N C: Decentralized management style

Answer 13

1. Gives more control to subsidiary managers who are closer to the subsidiary’s operation and environment.
2. Increase agency costs

Question 14

Theory of Comparative Advantage:

Answer 14

Specialization increases production efficiency.

Question 15

Imperfect Markets Theory:

Answer 15

Factors of production are somewhat immobile, providing incentive to seek out foreign opportunities.

Question 16

Product Cycle Theory:

Answer 16

As a firm matures, it recognizes opportunities outside its domestic market. (Exhibit 1.2)

Question 17

Theory of Comparative Advantage

Answer 17

• Some countries have a technology advantage and other countries have an advantage in the cost of basic labor.
• Countries tend to use their advantages to specialize in the production of goods that can be produced with relative efficiency.
• A country that specializes in some products may not produce other products, so trade between countries is essential.
• Comparative advantages allow firms to penetrate foreign market

Note: Countries that specialize in tourism rely completely on international trade for most products. Although these islands could produce some goods, it is more efficient for them to specialize in tourism. That is, the islands are better off using some revenues earned from tourism to import products than attempting to produce all the products they need.

Question 18

Imperfect Markets Theory

Answer 18

1. If each country’s markets were closed to all other countries:
   - There would be no international business.
2. In extreme case, if markets are perfect then the factors of production are easily transferable:
   - This eliminates the comparative cost advantage which is rationale for international trade.
3. In real world, market are imperfect where factors of production are somewhat immobile:
   - Costs and often other restrictions affect the transfer of labor and other resources used for production
   - Provide an incentive for firms to seek out foreign opportunities

Question 19

Product cycle theory

Answer 19

1. According to this theory, Firm first established its operation in home market:
   - Because information about home markets and competition is more readily available.
2. Firm’s product is perceived by foreign consumers to be superior to that available within their own countries, the firm may accommodate foreign consumers by exporting.
3. If the firm’s product becomes very popular in foreign countries, it may produce the product in foreign markets, thereby reducing its transportation costs.
4. Firm’s foreign business diminishes or expands over time will depend on how successful it is at maintaining some advantage over its competition.

Question 20

How do Firms Engage in International Business?

Answer 20

1.International Trade
2. Licensing
3. Franchising
4. Joint Ventures
5. Acquisitions of Existing Operations
6. Establishment of New Foreign Subsidiaries

Question 21

International Trade:

Answer 21

1. Relatively conservative approach that can be used by firms to:
   –> penetrate markets (by exporting).
   –> obtain supplies at a low cost (by importing).
2. Minimal risk — no capital at risk
   - Example: Boeing, DuPont, General Electric

Question 22

Licensing:

Answer 22

Obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names) in exchange for fees or some other specified benefits.

Firm able to generate more revenue from foreign countries without establishing any production plants in foreign countries or transporting goods to foreign countries.

Examples: Batman character is licensed to Lego

Question 23

Franchising

Answer 23

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.

Franchising by an M N C often requires a direct investment in foreign operations, it is referred to as a direct foreign investment (DFI).

Examples: McDonald’s, Pizza Hut, Subway, and Dairy Queen have franchises that are owned and managed by local residents in many foreign countries.

• As part of its franchising arrangements, McDonald’s typically purchases the land and establishes the building. It then leases the building to a franchisee and allows the franchisee to operate the business in the building for a specified number of years (such as20 years), but the franchisee must follow standards set by McDonald’s when operating the business.

Question 24

Joint Ventures

Answer 24

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 (or more) firms to apply their respective cooperative advantages in a given project.

Joint ventures often require some degree of DFI.

–> Example: Xerox Corp. and Fuji Co. (of Japan) engaged in a joint venture that allowed Xerox to penetrate the Japanese market while allowing Fuji to enter the photocopying business; General Motors has ongoing joint ventures with automobile manufacturers in several different countries.

Question 25

Acquisitions of Existing Operations:

Answer 25

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. They require DFI.

Subject to the risk of large losses because of larger investment.

Liquidation may be difficult if the foreign subsidiary performs poorly.

Partial international acquisitions (less than 100% acquisition) requires a smaller investment and limits the potential loss to the firm if the project fails.

Firm will not have complete control over foreign operations that are only partially acquired

–> Example: Alphabet, the parent of Google, has made major international acquisitions to expand its business and improve its technology in Australia, Brazil, Canada, China, Finland etc.

Question 26

Establishment of New Foreign Subsidiaries

Answer 26

Firms can penetrate markets by establishing new operations in foreign countries.

Large DFI required.

Operations can be tailored exactly to the firm’s needs.

Firm will not reap any rewards from the investment until the subsidiary is built and a customer base established.

–> Example: Toyota Motor Manufacturing Canada

Question 27

Summary of Methods:

Answer 27

Any method of increasing international business that requires a direct investment in foreign operations is referred to as direct foreign investment (D F I).

International trade and licensing usually not included.

Foreign acquisition and establishment of new foreign subsidiaries represent the largest portion of D F I.

Question 28

Dollar Cash Flows:

Answer 28

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.

Question 29

Cost of Capital

Answer 29

• 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 projects of a firm.

Question 30

Valuation of an M N C that uses two currencies

Answer 30

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.

Derive an expected dollar cash flow value for each currency

Combine the cash flows among currencies within a given period

Question 31

Valuation of an M N C’s cash flows over multiple periods:

Answer 31

Apply single period process to all future periods

Discount the estimated total dollar cash flow for each period at the weighted cost of capital

Question 32

Uncertainty Surrounding M N C Cash Flows:

Answer 32

1. Exposure to international economic conditions — If economic conditions in a foreign country weaken, purchase of products decline and M N C sales in that country may be lower than expected. (Exhibit 1.5)
2. Exposure to international political risk — A foreign government may increase taxes or impose barriers on the MNC’s subsidiary.
3. Exposure to exchange rate risk — If foreign currencies related to the M N C subsidiary weaken against the U.S. dollar, the M N C will receive a lower amount of dollar cash flows than expected.

Question 33

How Uncertainty Affects the M N C’s cost of Capital:

Answer 33

1. Due to increase in uncertainty of an M N C’s future cash flows, investor’s expectations increases with higher expected rate of return as leading to increase in cost of obtaining capital and reduction in valuation.
   Uncertainty of future CF increases –> k increases –> V decreases

If the uncertainty surrounding economic conditions that influence cash flows declines, the uncertainty surrounding cash flows of M N Cs also declines and results in a lower required rate of return and cost of capital for M N Cs. And result in increase in valuations.
Uncertainty of future CF decreases –> k decreases –> V increases