Explain the chosen international finance topic in general terms AND cover how it is implemented in the students chosen pretend business. 5. Paper will be a minimum of 750 and

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International Financial Management

11th Edition

by Jeff Madura

1

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Part 1

The International Financial Environment

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1 Multinational Financial Management: An Overview

 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

3

Chapter Objectives

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Managing the MNC

1. Managers are expected to make decisions that

will maximize the stock price.

2. Focus of this text: MNCs whose parents fully

own foreign subsidiaries (U.S. parent is sole

owner of subsidiary.)

3. Finance decisions are influenced by other

business discipline functions:

 Marketing

 Management

 Accounting and information systems

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Agency Problems

The conflict of goals between managers and

shareholders

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Agency Costs

1. Definition: Cost of ensuring that managers

maximize shareholder wealth

2. 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.

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Control of Agency Problems

1. 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.

2. Corporate control of agency problems Entire management of the MNC must be focused on maximizing

shareholder wealth.

3. Sarbanes-Oxley Act (SOX) Ensures a more transparent process for managers to report on the

productivity and financial condition of their firm.

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SOX Methods to Improve Reporting

 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

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Management Structure of MNC

1. Centralized (See Exhibit 1.1a)

Allows managers of the parent to control

foreign subsidiaries and therefore reduce the

power of subsidiary managers

2. Decentralized (See Exhibit 1.1b)

Gives more control to subsidiary managers

who are closer to the subsidiary’s operation

and environment

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Exhibit 1.1a Management Styles of MNCs

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Exhibit 1.1b Management Styles of MNCs

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Why Firms Pursue International Business

1. Theory of Competitive Advantage: specialization

increases production efficiency.

2. Imperfect Markets Theory: factors of production are

somewhat immobile providing incentive to seek out

foreign opportunities.

3. Product Cycle Theory: as a firm matures, it

recognizes opportunities outside its domestic

market.

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Exhibit 1.2 International Product Life Cycles

13

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How Firms Engage in International Business

1. International trade

2. Licensing

3. Franchising

4. Joint Ventures

5. Acquisitions of existing operations

6. Establishing new foreign subsidiaries

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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

 The internet facilitates international trade by

allowing firms to advertise their products and

accept orders on their websites.

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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

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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.

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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.

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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.

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Establishing 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.

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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.

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Exhibit 1.3 Cash Flow Diagrams for MNCs

22

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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.

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Uncertainty Surrounding MNC Cash Flows

1. 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.

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 MNC subsidiary weaken against the U.S.

dollar, the MNC will receive a lower amount of dollar cash

flows than was expected.

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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.

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Exhibit 1.5 Organization of Chapters

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Summary

 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.

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Summary

International business is justified by three key theories.

1. 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.

2. 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.

3. The product cycle theory suggests that after firms are

established in their home countries, they commonly

expand their product specialization in foreign countries.

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Summary

 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.

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Summary

 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 11th Edition

by Jeff Madura

1

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2

3 International Financial Markets

Describe the background and corporate use of the following International Financial Markets:

 Foreign exchange market

 International money market

 International credit market

 International bond market

 International stock markets

2

Chapter Objectives

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3

Foreign Exchange Market

1. Allows for the exchange of one currency for another.

2. Exchange rate specifies the rate at which one currency can be exchanged for another.

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4

History of Foreign Exchange

1. Gold Standard (1876 – 1913) Each currency was convertible into gold at a specified rate. When World War I began in 1914, the gold standard was suspended.

2. Agreements on Fixed Exchange Rates a.Bretton Woods Agreement 1944 – 1971

b.Smithsonian Agreement 1971 – 1973

3. Floating Exchange Rate System Widely traded currencies were allowed to fluctuate in accordance with market forces

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5

Foreign Exchange Transactions

1. The over-the-counter market is the telecommunications network where companies normally exchange one currency for another.

2. Foreign exchange dealers serve as intermediaries in the foreign exchange market

3. A foreign exchange transaction for immediate exchange is said to trade in the spot market. The exchange rate in the spot market is the spot rate.

4. Trading between banks occurs in the interbank market.

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6

Spot Market

1. The U.S. Dollar is the commonly accepted medium of exchange in the spot market.

2. Spot market time zones – Foreign exchange trading is conducted only during normal business hours in a given location. Thus, at any given time on a weekday, somewhere around the world a bank is open and ready to accommodate foreign exchange requests.

3. Spot market liquidity: More buyers and sellers means more liquidity.

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7

Attributes of Banks That Provide Foreign Exchange

1. Competitiveness of quote

2. Special relationship with the bank

3. Speed of execution

4. Advice about current market conditions

5. Forecasting advice

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8

Foreign Exchange Quotations

rateAsk

rate Bid rateAsk spreadask / Bid

 

1. At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote.

2. The bid/ask spread covers the bank’s cost of conducting foreign exchange transactions

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9

Exhibit 3.1 Computation of the Bid Ask Spread

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