International Financial Management Ch. 1

What is the goal of a financial manager?
To maximize shareholder wealth, the value of the firm, and stock price.
MNC
Multi National Corporation
Common Finance Decisions
1) Whether to discontinue operations in a particular country
2) Whether to pursue new business in a particular country
3) Whether to expand business in a particular country
4) How to finance expansion into a particular country
What other business disciplines influence finance?
Marketing, Management, Accounting and MIS
Agency Problem
The conflict of goals between managers and shareholders
Agency Costs
Cost of ensuring that managers maximize shareholder wealth
Who has highest agency costs?
MNC over domestic firms
Why do MNC have high agency problem?
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 MNCs can create large agency problem.
4) Some non-US managers tend to downplay the short-term effects of decisions. THEY ONLY CARE ABOUT THAT SUBSIDIARY
Parent Control of Agency Problem
Parent should clearly communicate the goals for each subsidiary to ensure managers focus on MAXIMIZING THE VALUE OF THE MNC, not their individual subsidiary.

Common incentive: provide managers with MNC stock

Corporate Control Agency Problem
Entire management of the MNC must be focused on maximizing shareholder wealth.

REDIRECT CORPORATE STRATEGY TO MOTIVATE MANAGERS TO WORK TOWARD THE FIRM’S GOAL, NOT JUST THE SUBSIDIARY.

Sarbanes-Oxley Act (SOX)
Ensures a more transparent process for managers to report on the productivity and financial condition of their firm.

MAKES SURE FINANCIAL REPORTING BY MANAGERS IS ACCURATE

How did SOX improve corporate governance of MNCs?
1) Establish centralized database of information
2) Ensuring all data are reported consistently among subsidiaries
3) Implementing a system that automatically checks for unusual discrepancies relative to norms
4) Speeding up process to get departments and subsidiaries access to data they need
5) Make executives more accountable for financial statements
Centralized Management Structure
Financial manager of PARENT controls all decisions made about subsidiaries

ADVANTAGE: Lower agency problem
DISADVANTAGE: Worse decision making (parent is far away)

Decentralized Management Structure
Gives more control to SUBSIDIARY managers.

ADVANTAGE: Better decision making. (Subsidiary manager is physically there)
DISADVANTAGE: High agency problem.

DECENTRALIZED – HIGH AGENCY PROBLEM

Internet Facilities Management Control
Easier for parent to monitor the actions and performance of its foreign subsidiaries.
What are the 3 theories that justify why firm’s pursue international business?
1) Theory of Competitive Advantage
2) Imperfect Markets Theory
3) Product Cycle Theory
Theory of Competitive Advantage
SPECIALIZATION increases production efficiency.

Country should produce what they specialize in. Rely on int’l trade for other goods and services. Certain countries have competitive advantage in certain areas.

Imperfect Markets Theory
Factors of production are somewhat immobile providing incentive to seek out foreign opportunities.

Markets are imperfect and things like intelligence can’t be easily transferred to other markets. IMPERFECT MARKETS give us a COMPETITIVE ADVANTAGE (tied together)

Product Cycle Theory
As a firm matures, it recognizes opportunities outside its domestic market

As a FIRM EXPANDS it penetrates FOREIGN COUNTRIES AND MARKETS.

How Firm’s Engage in International Business
1) International Trade
2) Licensing
3) Franchising
4) Joint Ventures
5) Acquisitions of Existing Operations
6) Establishing New Foreign Subsidiaries
International Trade
CONSERVATIVE APPROACH. IMPORTS/EXPORTS

Imports – Obtain supplies at low cost
Exports – Penetrate market

NO CAPITAL INVESTMENT

Licensing
Obligates a firm to provide technology (ex. copyright, patent, trademark, trade name) in exchange for fees or other specified benefits.

Give rights to a foreign firm to use your brand.

Advantage: No major investment by US firm and no transportation costs that would come from exporting.
Disadvantage: Difficult to ensure quality control.

NO CAPITAL INVESTMENT BY US FIRM

Franchising
Obligates a firm to provide a specialized sales or service strategy, support assistance, and possibly initial investment in franchise in exchange for periodic fees

Advantage: Allows penetration in foreign markets w/o investment in foreign countries. US company still has control of franchise

CAPITAL INVESTMENT BY US FIRM

Joint Ventures
A venture jointly owned and operated by two or more firms. A firm can enter a foreign market by forming a joint venture with a firm already in that market.

Advantage: allows two firms to apply their respective cooperative advantages in a given project.

BOTH US AND FOREIGN INVESTMENT

Acquisition 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.

Disadvantage: Could have large losses b/c of large investment. LIqUIDATION MAY BE DIFFICULT if foreign subsidiary performs poorly.

LOTS OF US INVESTMENT (MOST OF ANY OPTION)

Establishing New Foreign Subsidiary
Firms can penetrate market by establishing new operations in foreign countries.

Disadvantage: requires a lot of investment.
Advantage: Acquiring new instead of buying existing allows operations to be tailored to exactly what the firm needs. May be smaller investment than acquisition of existing firm.

LOTS OF US FIRM INVESTMENT, BUT LESS THAN ACQUISITION OF EXISTING OPERATIONS

DFI
Direct Foreign Investment
Methods with no DFI
International Trade
Licencing
Methods with the most DFI
Foreign acquisition
Establishment of a new foreign subsidiary
Valuation Model for MNC
E(CF) = sum[E(CFforeign)*E(S exchange rate)]
Uncertainty Surrounding MNC Cash Flows
1) Exposure to international economic conditions
2) Exposure to international political risk
3) Exposure to exchange rate risk
Exposure to International Economic Conditions
If economic conditions in a foreign country get weaker, people buy less of that firm’s products so MNC sales will be lower.

IF FOREIGN ECONOMY GETS WORSE, THEN THE SUBSIDIARY WILL LOSE MONEY

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 US dollar, the MNC will receive a lower amount of dollar cash flows then was expected.

IF FOREIGN CURRENCY APPRECIATES THEN THE MNCs MONEY WILL INCREASE.

BIGGEST RISK

Which models of foreign investment have exchange rate risk?
ALL OF THEM.

How to manage exposure:
International trade: You can make short term decisions so you have less exposure

New Subsidiary: US wants foreign currency to appreciate in the short term and depreciate in the long term.

How Uncertainty Affects MNC’s Cost of Capital
HIGH level of uncertainty INCREASES the return on investment required by investors and the MNC’s valuation DECREASES.