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Lecture multinational financial management chapter 1 ngo thi ngoc huyen

WHAT IS THE STUDY OF INTERNATIONAL
FINANCE?

CHAPTER
ONE

MNCs & MULTINATIONAL
FINANCIAL MANAGEMENT







Making investment and financing
Decisions in a global market.
Cash flows associated with these decisions
Risks associated with these cash flows
The international financial markets


3

WHAT’S SPECIAL ABOUT
“INTERNATIONAL” FINANCE?

CHAPTER ONE OVERVIEW






What’s Special about “International” Finance?
Goals of MNC
The rise of the MNCs
The Internationalization of Business & Finance
Multinational Financial Management: Theory & practice






Foreign Exchange Risk
Political Risk
Market Imperfections
Expanded Opportunity Set

1-4

1


WHAT’S SPECIAL ABOUT
“INTERNATIONAL” FINANCE?

WHAT’S SPECIAL ABOUT
“INTERNATIONAL” FINANCE?
• Foreign Exchange Risk

• Market Imperfections

– This is risk that foreign currency profits may evaporate in
dollar terms due to unanticipated unfavorable exchange
rate movements.
– Suppose $1 = ¥100 and you buy 10 shares of Toyota at
¥10,000 per share. One year later the investment is worth
ten percent more in yen: ¥110,000.
– But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.

– Legal restrictions on the movement of goods,
people, and money
– Transactions costs
– Shipping costs
– Tax arbitrage

1-5

WHAT’S SPECIAL ABOUT
“INTERNATIONAL” FINANCE?

1-7

THE EXAMPLE OF NESTLÉ’S MARKET IMPERFECTION
• Nestlé used to issue two different classes of common
stock bearer shares and registered shares.

• Political Risk
– Sovereign governments have the right to regulate
the movement of goods, capital, and people
across their borders. These laws sometimes
change in unexpected ways.

– Foreigners were only allowed to buy bearer shares.
– Swiss citizens could buy registered shares.
– The bearer stock was more expensive.

• On November 18, 1988, Nestlé lifted restrictions
imposed on foreigners, allowing them to hold
registered shares as well as bearer shares.

1-6

1-8

2


WHAT’S SPECIAL ABOUT
“INTERNATIONAL” FINANCE?

NESTLÉ’S FOREIGN OWNERSHIP RESTRICTIONS

• Expanded Opportunity Set
12,000
10,000

– It doesn’t make sense to play in only one corner of
the sandbox.
– True for corporations as well as individual
investors.

Bearer share

SF

8,000
6,000
4,000

Registered share

2,000
0
11

20

31

9

18

24

Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
1-9

THE EXAMPLE OF NESTLÉ’S MARKET IMPERFECTION
• Following this, the price spread between the two
types of shares narrowed dramatically.

1-11

GOALS FOR INTERNATIONAL FINANCIAL
MANAGEMENT
• Maximization of shareholder wealth?
or
• Other goals?

– This implies that there was a major transfer of wealth from
foreign shareholders to Swiss shareholders.

• Foreigners holding Nestlé bearer shares were
exposed to political risk in a country that is widely
viewed as a haven from such risk.
• The Nestlé episode illustrates both the importance of
considering market imperfections and the peril of
political risk.
1-10

1-12

3


OTHER GOALS

MULTINATIONAL CORPORATION

• In other countries shareholders are viewed as
merely one among many “stakeholders” of the
firm including:

• Goal of MNCs is maximizing shareholder’s wealth
– The SWM model – Shareholder Wealth Maximization (US company)

– Employees
– Suppliers
– Customers

• In Japan, managers have typically sought to
maximize the value of the keiretsu—a family of
firms to which the individual firms belongs.

– The CWM model – Corporate Wealth Maximization (European & Japanese
company): requires a single goal of value maximization with a well-defined score
card

1-15

13

OTHER GOALS

MAXIMIZE SHAREHOLDER WEALTH

• As shown by a series of recent corporate scandals at
companies like Enron, WorldCom, and Global
Crossing, managers may pursue their own private
interests at the expense of shareholders when they
are not closely monitored.
• These calamities have painfully reinforced the
importance of corporate governance, i.e., the
financial and legal framework for regulating the
relationship between a firm’s management and its
shareholders.

• Long accepted as a goal in the Anglo-Saxon
countries, but complications arise.
– Who are and where are the shareholders?
– In what currency should we maximize their
wealth?

1-14

1-16

4


OTHER GOALS

THEORIES OF INTERNATIONAL BUSINESS

• These types of issues can be much more serious in
many other parts of the world, especially emerging and
transitional economies, such as Indonesia, Korea, and
Russia, where legal protection of shareholders is weak
or virtually non-existing.
• No matter what the other goals, they cannot be
achieved in the long term if the maximization of
shareholder wealth is not given due consideration.

 Imperfect Markets #1
 Comparative Advantage #
 Product Cycle #2
 “A Flat World” #3

1-17

19

INTERNATIONAL FINANCIAL MARKET

INTERNATIONAL FINANCIAL MARKET

• Involves the study of:
– Exchange rate regimes

Foreign
Exchange
Markets

– Financial institutions

Sourcing
Capital in
Global Markets

– Financial instruments
– International finance models

International
Financial
Management

– Current international finance issues.

Synthesis

• The focus is to understand how The markets, instruments,
risks and rewards affect investment and financing decisions
Managing
FOREX
Exposure

18

Foreign
Investment
Decisions

20

5


DEGREE OF INTERNATIONALIZATION RELATED TO THE INVOLVEMENT OF
CAPITAL AND MANAGEMENT IN THE HOME COUNTRY AND THE HOST COUNTRY

MULTINATIONAL CORPORATION
• 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.
• There are about 60,000 MNCs in the world.
– MNCs are reshaping the structure of the world economy.
– The true MNCs emphasizes group performance rather than the
performance of its individual parts.
– MNC may gain from their global presence in a variety of way. First of all,
MNC can benefit from the economy of scale by (1) spreading R&D
expenditures and advertising costs over their global sales, (2) pooling
global purchasing power over suppliers, (3) utilizing their technological
and managerial know-how globally with minimum additional costs …
– MNCs can use their global presence to take advantage of underpriced
labor service available in LDCs
– Companies are increasingly using offshore outsourcing as a way of saving
costs and boosting productivity.

In the host
country

100%

Affiliate
Production plant
Foreign branch
Joint venture
Franchising
License Agreement

In the
home
country

Export
100%
In the home
country

21

In the host country
23

Involvement of management

TYPICAL FOREIGN EXPANSION SEQUENCE

BASIC TYPES OF MNCS
There are three basic types of MNCs.

Licensing

• Raw-materials seekers
• Market seekers.
• Cost minimizes.

Exporting

In all cases, MNCs involved recognize that the world is larger than the home

Sales

Service

Distribution

Production

subsidiary

facilities

system

oversea

country and provides opportunities to gain additions supplies, sell more
products or find lower cost sources of production.

22

24

6


THE PROCESS OF OVERSEA EXPANSION

OPERATING & FINANCING CASH FLOWS

The process of international expansion ordinarily evolves from a low risk
low-return to a higher -risk-higher return strategy
• Exporting. Exporting is a low cost, low risk strategy for learning about
and developing foreign markets. At the same time, internet limits a
company’s ability to fully exploit foreign markets.
• Oversea production.
A company can more easily keep abreast of market developments,
Adapt its products to local tastes and conditions
and provide more comprehensive after sales-service
Foreign production often requires a substantial capital investment, internet
may allow company access lower cost local labor and materials.
– Internet also demonstrates a tangible commitment to local market and an
increased assurance of supply stability





Financial Cash Flows
Dividend paid to parent
Parent invested equity capital
Interest on intrafirm lending
Intrafirm principal payments

Parent

Subsidiary

Payment for goods & services
Rent and lease payments
Royalties and license fees
Management fees & distributed overhead

Operational Cash Flows

25

27

Dividends
Fees, Royalties, corporate overhead for services

THE PROCESS OF OVERSEA EXPANSION

Interest and repayment of credit/loan
Equity investment
Loans
Credit on goods and services

• Licensing. Foreign licensing tends to be a low risk - low return strategy

26

Capital goods
Technology
Management
Intermediate goods
Finished goods
Technology/market intelligence

Financial
flows

– Instead of spending money to set up production facilities abroad, company
can license a local firm to manufacture its products
– Licensing allows the company access its licensee’s marketing smarts and
distribution network.
– The principal advantages of licensing are the minimal investment required,
faster market entry, and fewer financial and legal risks involved
– However, licensing may create a competitive in other markets because
internet is often difficult to control exports by foreign licensees.
– It may also be dificult to displace the licensee in the local market once the
license expires
– Cash flow is relatively low, and there may be problems in maintaining
product quality standards

28

Alan C Sharpiro, Multinational Financial Management, 9th edition, Willey & son

7


MULTINATIONAL FINANCIAL MANAGEMENT

MULTINATIONAL FINANCIAL MANAGEMENT
• MNC has considerable freedom in selecting the financial channels
through which funds and allocated profits are moved.
• In addition, MNCs have some flexibility regarding the timing of fund
flows. They can speed up or slow down dividend payments, loan
repayments, and payments for fees, royalties, and interaffiliate sales
of goods and services.
• The different modes of internal fund transfers available to the MNC:






• Timing flexibility

Transfer prices on goods and services traded internally
Intercompany loans and equity investment
Dividend payments
Leading (speeding up) and lagging (slow down) intercompany payments
Fees and royalty charges



– Leading and lagging is most often applied to interaffiliate trade credit.
– MNCs have the greatest amount of flexibility in the timing of equity
claims. The earning of a affiliate can be retained or used to pay dividends
that in turn can be deferred or paid in advance
– MNCs have some flexibility in the timing of fund flows even the frequent
presence of government regulations or limited contractual arrangement
– MNCs have been able to control the timing of many of the underlying
real transaction
Value. The ability of MNCs to avoid taxes and regulatory barriers by shifting
money and profit among their various units has led to conflicts with nationstates

29

MULTINATIONAL FINANCIAL MANAGEMENT

31

FOUNDATIONS OF INTERNATIONAL FINANCIAL
• Three basic concepts provide the foundation for study of international
finance: arbitrage, market efficiency, and capital asset pricing model
• Arbitrage: Taxes arbitrage, risk arbitrage, currency arbitrage…
• Market efficiency:

• The multinational firm can control the mode and timing of internal
financial transfers and thereby maximize global profit.
• Mode of transfer. MNCs have freedom in selecting the financial channels
through which funds, allocated profit, or both are moved. Ex.
– MNC can move profits and cash from one unit to another by adjusted
transfer prices on intercompany sales and purchases of goods and
services
– Capital can be sent overseas as debt
– Regarding to the limits of various national laws, MNC can take more
advantage than independent company

– An efficient market is one which new information is readily incorporated
in the price of traded securities . In an efficient market can not expect to
prosper by finding overvalued or undervalued assets.
– All funds require the same risk-adjusted returns
– Absent tax consideration or government intervention, market efficiency
suggests that there are no financing bargains available

30

32

8


ROLE OF THE FINANCIAL EXECUTIVE IN AN EFFICIENT
MARKET

VALUATION MODEL FOR MNC
• DOMESTIC MODEL

• Financial executives of MNCs face added political and economic risks,

 m

E CF$, t 
n 


Value =   j 1

t


1 k
t =1 




as well as more complex tax laws and multiple money markets.
• Financial managers can create value by taking advantage of capital
market imperfections and tax asymmetries

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
received
k
= the required rate of return by investors

33

INTERNATIONAL OPPORTUNITIES

VALUATION MODEL FOR MNC

Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Purely
Domestic
Firm

Investment
Opportunities
Marginal
Return on
Projects

• VALUING INTERNATIONAL CASH FLOWS

m
E CFj , t  E ER j , t 
n 


Value =   j 1

t
1  k 
t =1 




MNC
MNC
Purely
Domestic
Firm

Marginal
Cost of
Capital
Financing
Opportunities

Appropriate Size for
Purely Domestic
Firm

X

Y

Appropriate Size for
MNC

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

Asset Level
of Firm
34

9


GLOBALIZATION OF THE WORLD ECONOMY: MAJOR TRENDS
AND DEVELOPMENTS








EMERGENCE OF THE EURO AS A GLOBAL CURRENCY

Emergence of Globalized Financial Markets
Emergence of the Euro as a Global Currency
Europe’s Sovereign Debt Crisis of 2010
Trade Liberalization and Economic Integration
Privatization
Global Financial Crisis of 2008-2009

• A momentous event in the history of world financial systems.
• Currently more than 300 million Europeans in 16 countries are
using the common currency on a daily basis.
• In May 2004, 10 more countries joined the European Union.
• The “transaction domain” of the euro may become larger than
the U.S. dollar’s in the near future.

1-37

EMERGENCE OF GLOBALIZED FINANCIAL MARKETS

EUROPE’S SOVEREIGN-DEBT CRISIS OF 2010
• In December of 2009 the new Greek government
revealed that its budget deficit for the year would be
12.7% of GDP, not the 3.7% forecast.
• Investors sold off Greek government bonds and the
ratings agencies downgraded them to “junk.”
• While Greece represents only 2.5% of euro-zone GDP,
the crisis became a Europe-wide debt crisis.
• The challenge remains that fiscal indiscipline of one
euro-zone country can escalate to a Europe-wide crisis.

• Deregulation of Financial Markets coupled with
• Advances in Technology
– have greatly reduced information and transaction
costs, which has led to:
• Financial Innovations, such as





1-39

Currency futures and options
Multi-currency bonds
Cross-border stock listings
International mutual funds

1-38

1-40

10


LIBERALIZATION OF PROTECTIONIST LEGISLATION

THE GREEK DRAMA

• The General Agreement on Tariffs and Trade (GATT)
is a multilateral agreement among member
countries that has reduced many barriers to trade.
• The World Trade Organization has the power to
enforce the rules of international trade.
• On January 1, 2005, the era of quotas on imported
textiles ended.
• This is an event of historic proportions.
• Greece paid no premium above the German rate until late fall 2009.
• The Greek interest rate rose until the bailout package on May 9.
1-41

1-43

ECONOMIC INTEGRATION

NAFTA

• Over the past 50 years, international trade increased
about twice as fast as world GDP.
• There has been a change in the attitudes of many of
the world’s governments, who have abandoned
mercantilist views and embraced free trade as the
surest route to prosperity for their citizenry.

• The North American Free Trade Agreement (NAFTA)
calls for phasing out impediments to trade between
Canada, Mexico, and the United States over a 15year period beginning in 1994.
• For Mexico, the ratio of export to GDP has increased
dramatically from 2.2% in 1973 to 29% in 2006.
• The increased trade has resulted in increased
numbers of jobs and a higher standard of living for all
member nations.

1-42

1-44

11


PRIVATIZATION

GLOBAL FINANCIAL CRISIS OF 2008—2009

• The selling of state-run enterprises to investors is
also known as “denationalization.”
• Privatization is often seen in socialist economies in
transition to market economies.
• By most estimates, this increases the efficiency of
the enterprise.
• It also often spurs a tremendous increase in crossborder investment.

• The “Great Recession” was the most serious,
synchronized economic downturn since the Great
Depression of the 1930s.
• Factors included:
– Households and financial institutions borrowed too much
and took too much risk.
– This risk was repackaged with securitization, and so
defaults on subprime mortgages in the U.S. came to
threaten the solvency of a teacher’s retirement plans in
Norway.

1-45

CHINESE PRIVATIZATION

1-47

GLOBAL FINANCIAL CRISIS 2008—2009

• State-owned enterprises have been listed on
organized stock exchanges.
• More than 1,500 companies are currently listed on
China’s stock exchanges.
• The Chinese government still retains the majority
stakes in most public firms.
• Chinese citizens can buy “A” shares, while foreigners
are limited to “B” shares.
• During the course of the crisis, the G-20 emerged as the premier forum for
discussing international economic issues and coordinating financial
regulations and macroeconomic policies.
1-46

1-48

12


THE GEOMETRY OF COMPARATIVE ADVANTAGE

THE FOLLOWING SLIDES COVER THE APPENDIX
TO CHAPTER 1.

• Consider the example where there are two countries,
A and B, who can each produce only food and
textiles.
• Initially they do not trade with one another.
• The graph on the next slide shows the increase in
consumption available to the citizens of countries A
and B with trade arising from the differences in their
opportunity costs of production.

1-49

THE THEORY OF COMPARATIVE ADVANTAGE

1-51

THE GEOMETRY OF COMPARATIVE ADVANTAGE
A production possibilities curve shows quantities of food or textiles each country can make.

• A comparative advantage exists when one party can
produce a good or service at a lower opportunity cost
than another party.
• The opportunity cost of making one additional unit of a
good (or service) can be defined as the value of some
other good that you have to give up in order to
produce this additional unit.

Textiles

The production possibilities of Country A are such that if they
concentrated 100% of their resources into the production of textiles,
they could produce 180 million yards of textiles.
If Country A chose to concentrate 100% of their resources into the
production of food, they could produce as much as 300 million
pounds of food.
Country A can produce any combination of food and textiles
between these two points.

180

– For example, if you can work as many hours as you like at your current
employer and get paid $10 per hour, then the opportunity cost of your
leisure is $10 per hour.

As a practical matter, the citizens of Country A must choose a point
along their production possibilities curve.

60
200 300
1-50

Suppose they initially choose 200m pounds of food and 60m yards of textiles.

Food
1-52

13


THE GEOMETRY OF COMPARATIVE ADVANTAGE

Textiles

THE GEOMETRY OF COMPARATIVE ADVANTAGE
Without trade, if both countries make only food, the combined production
would be 1,200 million pounds of food = 900 + 300.

If Country B chose to concentrate 100% of their resources into the
production of textiles, they could produce 240 million yards of textiles.
If Country B chose to concentrate 100% of their resources into the
production of food, they could produce 900 million pounds of food.

240
180

The citizens of Country B must also choose a point along their
production possibilities curve;

80
60
Food
200 300
600
900
1,200
Initially they choose 600 million pounds of food, and 80 million yards of textiles.
1-53

THE GEOMETRY OF COMPARATIVE ADVANTAGE
Textiles

Put another way, country B enjoys a comparative advantage in
food because they have to give up textiles at a lower rate than A
when making more food.
Geometrically, a comparative advantage exists because the slopes of
the production possibilities differ.

240
180

If the countries specialize according to their comparative advantage,
then Country A should make textiles and trade for food, while Country
B should grow food and trade for textiles.

80
60
Food
200 300

600

900

Country A enjoys a comparative advantage in textiles because they have to give up food
at a lower rate than B when making textiles.
1-54

Textiles

The combined production possibilities curve of country A and B
without trade are shown in the green line.

420

Before trade, combined consumption is 800 million lbs of food (=
200 + 600) and 140 million yards of textiles (= 60 + 80).

240
180
140
80
60
Food
200 300

600

800 900

1,200

Without trade, if both countries make only textiles, the combined production would
be 420 million yards of textiles = 240 + 180.

1-55

A production
possibilities
curve
shows the in
various
amounts
of they
food have
GEOMETRY
OFadvantage
COMPARATIVE
ADVANTAGE
Country
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Without
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or textiles that each country can make.
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than
B when
making
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420
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Country
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Without
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produce the first 180 million yards of textiles.
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900
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Country
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180
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while country
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As
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80
choose a point along
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80
60
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Food
Food
200
800
1,200
200 300
300Suppose 600
600
800 900
900
1,200
that
initially
they
choose
200
million
County B can produce food at a lower opportunity cost, so let B produce the first 900
pounds of food, and 60 million yards of textiles.
1-56
million pounds of food.

14


ARGUMENTS IN FAVOR OF FREE TRADE

QUESTION?
1. Why is it important to study international financial management?
2. How is international financial management different from domestic financial
management?
3. What are multinational corporations (MNCs) and what economic roles do they play?
4. Suppose you are interested in investing in shares of Nokia Corporation of Finland,
which is a world leader in wireless communication. But before you make investment
decision, you would like to learn about the company. Visit the website of Yahoo
(finance.yahoo.com) and collect information about Nokia, including the recent stock
price history and analysts’ views of the company. Discuss what you learn about the
company. Also discuss how the instantaneous access to information via internet would
affect the nature and workings of financial markets.

• Both partners gain from trade; we have more
material goods.
• “Freedom” is a good thing in and of itself.
– In this case, consumers have the freedom to choose
imported goods and producers have the freedom to
choose to sell to foreigners.

1-57

59

MINI CASE: NIKE AND SWEATSHOP LABOR
Discussion points
1. Do you think the criticism of Nike is fair, considering that the host
countries are in dire needs of creating jobs?
2. What do you think Nike’s executives might have done differently
to prevent the sensitive charges of sweatshop labor in overseas
factories?
3. Do firms need to consider the so-called corporate social
responsibilities in making investment decisions?

58

OPPORTUNITY COST #
The opportunity cost of good
X in term of good Y

Number of units of good Y/
= Number of units good X

Product #1

Product #2

$1 buys 2 candies

$1 buys 4 stamps

1 candy = 4/2 = 2 stamps

Opportunity Cost
1 stamp =2/4=0.5 candies

$1,000,000 buys
4 cars

$1,000,000 buys
10 boats

1 car = 10/4 = 2.5 boats

1 boat =4/10=0.4 cars

Output /hour = 25
calculators

Output /hour = 5
computers

1 calculator = 5/25=0.2
computers

1 computers = 25/5= 5
calculators

1 worker can
produce 8000lbs
of wheat

1 worker can
produce 2000lbs
of cotton

1 lbs of wheat =
2000/8000 = 0.25lbs of
cotton

1 lbs of cotton = 8000/2000
= 4 lbs of wheat

60

15


SOLUTION IN-CLASS EXERCISE # 2
TOTAL OUTPUT PER WORKER
BRAZIL
CHINA

COFFEE

TEA

9000 lbs

300 lbs

5000 lbs

200 lbs

OPPORTUNITY COST
Cost of TEA (in term of Cof)

Cost of Cof. (in term of tea)

BRAZIL

CHINA

BRAZIL
CHINA
1 pound of tea = 32 lb Cof.
1 pound of cof = 0.035 lb tea
1 pound of cof = 0.065 lb tea
1 pound of tea = 20 lb Cof.
61

IN-CLASS EXERCISE # 3
TOTAL OUTPUT PER WORKER
FOOD (F)

CLOTHING (C)

USA

400

10

GERMANY

1000

20

OPPORTUNITY COST
COST OF F (in term of C)

COST OF C (in term of F)

USA

GERMANY

USA
GERMANY
1C=35F
1F=0.04C
1F=0.01C
1C=52F
62

16



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