IMF Madura Chapter 01 PDF

1
Multinational Financial
Management: An Overview
CHAPTER Multinational corporations (MNCs) are defined as firms that engage in

OBJECTIVES some form of international business. Their managers conduct international
The specific objectives
financial management, which involves international investing and financing
of this chapter are to: decisions that are intended to maximize the value of the MNC. The goal of
■ Identify the
these managers is to maximize their firm’s value, which is the same goal
management goal pursued by managers employed by strictly domestic companies.
and organizational
structure of the
Initially, firms may merely attempt to export products to a certain
MNC. country or import supplies from a foreign manufacturer. Over time, however,
■ Describe the key
many of these firms recognize additional foreign opportunities and even-
theories about tually establish subsidiaries in foreign countries. DowDuPont, IBM, Nike,
why MNCs engage and many other U.S. firms have more than half of their assets in foreign
in international
business. countries. Many technology firms, such as Apple, Facebook, and Twitter,
expand overseas in an effort to capitalize on their technology advantages.
■ Explain the
common methods Some businesses, such as ExxonMobil, Fortune Brands, and Colgate-
used to conduct Palmolive, commonly generate more than half of their sales in foreign
international
business. countries. Many smaller U.S. firms such as Ferro (Ohio) generate more than
20 percent of their sales in foreign markets. Likewise, some smaller private
■ Provide a model for
valuing the MNC. U.S. firms such as Republic of Tea (California) and Magic Seasoning Blends
(Louisiana) generate a substantial percentage of their sales in nondomestic
markets. In fact, 75 percent of U.S. firms that export products or services
have fewer than 100 employees.
International financial management is important even to companies
that have no international business. These companies must recognize how
their foreign competitors will be influenced by movements in exchange
rates, foreign interest rates, labor costs, and inflation. Such economic
characteristics can affect the foreign competitors’ costs of production and
pricing policies.
This chapter provides background on the goals, motives, and valuation
of a multinational corporation.
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4 Part 1: The International Financial Environment
1-1 Managing the MNC

The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers
employed by the MNC are expected to make decisions that will maximize the stock price,
thereby serving the shareholders’ interests. Some publicly traded MNCs based outside
the United States may have additional goals, such as satisfying their respective govern-
ments, creditors, or employees. Nevertheless, these MNCs place greater emphasis on their
primary goal of satisfying shareholders; that way, the firm can more easily obtain funds
from them to support its operations. Even in developing countries (for example, Bulgaria
and Vietnam) that have just recently encouraged the development of business enterprise,
managers of firms must serve shareholder interests if they hope to obtain funding from
investors.
The focus of this text is MNCs whose parents wholly own any foreign subsidiaries,
which means that the U.S. parent is the sole owner of the subsidiaries. This is the most
common form of ownership of U.S.-based MNCs, and it gives financial managers
throughout the firm the single goal of maximizing the entire MNC’s value (rather than
the value of any particular subsidiary). The concepts in this text also generally apply to
MNCs based in countries other than the United States.
1-1a How Business Disciplines Are Used to Manage the MNC

Various business disciplines are integrated to manage the MNC in a manner that maxi-
mizes shareholder wealth. Management develops strategies that will motivate and guide
employees who work in an MNC and to organize resources so that they can efficiently
produce products or services. Marketing seeks to increase consumer awareness about the
products and to recognize changes in consumer preferences. Accounting and information
systems record financial information about revenue and expenses of the MNC, which can
be used to report financial information to investors and to evaluate the outcomes of various
strategies implemented by the MNC. Finance makes investment and financing decisions
for the MNC. Common finance decisions include the following:
■ Whether to pursue new business in a particular country
■ Whether to expand business in a particular country
■ How to finance expansion in a particular country
■ Whether to discontinue operations in a particular country
These finance decisions for each MNC are partially influenced by the other business
discipline functions. The decision to pursue new business in a particular country depends
on a comparison of the costs and potential benefits of expansion. The potential benefits of
such new business reflect both the expected consumer interest in the products to be sold
(marketing function) and the expected cost of the resources needed to pursue the new
business (management function). Financial managers rely on financial data provided by
the accounting and information systems functions.
1-1b Agency Problems

Managers of an MNC may sometimes make decisions that conflict with the firm’s goal
of maximizing shareholder wealth. For example, a manager’s decision to establish a
subsidiary in one location versus another may be based on the location’s appeal to the
manager rather than on its potential benefits to shareholders. This conflict of goals between
a firm’s managers and shareholders is often referred to as the agency problem.
Chapter 1: Multinational Financial Management: An Overview 5
The costs of ensuring that managers maximize shareholder wealth (referred to as

agency costs) are typically larger for MNCs than they are for purely domestic firms, for
several reasons. First, MNCs with subsidiaries scattered around the world may experi-
ence larger agency problems because monitoring the managers of distant subsidiaries in
foreign countries is more difficult. Second, foreign subsidiary managers who are raised in
different cultures may not follow uniform goals. Some of them may believe that the first
priority should be to serve their respective employees. Third, the sheer size of the larger
MNCs can create significant agency problems, because it complicates the monitoring of
all managers.
EXAMPLE Two years ago, Seattle Co. (based in the United States) established a subsidiary in Singapore so that it could
expand its business there. It hired a few managers in Singapore to manage the subsidiary. During the last two
years, sales generated by the subsidiary have not grown. Even so, the managers in Singapore hired several
employees to do the work that they were assigned to do, and the subsidiary has incurred losses recently
because it is so poorly managed. The managers of the parent company in the United States have not closely
monitored the subsidiary in Singapore because it is so far away and because they trusted the managers
there. Now they realize that there is an agency problem, and the management in Singapore must be more
closely monitored. ●
Lack of monitoring can lead to substantial losses for MNCs. The large New York–based
bank JPMorgan Chase & Co. lost at least $6.2 billion and had to pay more than $1 billion in
fines and penalties after a trader in its office in London made extremely risky trades. The
subsequent investigation revealed that the bank had maintained poor internal controls and
failed to provide proper oversight of its employees.
Parent Control of Agency Problems The parent corporation of an MNC may be
able to prevent most agency problems with proper governance. The parent should clearly
communicate the goals for each subsidiary to ensure that all of them focus on maximizing
the value of the MNC, rather than the value of their respective subsidiaries. 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 man-
agers with the MNC’s stock (or options to buy that stock at a fixed price) as part of their
compensation; thus, the subsidiary managers benefit directly from a higher stock price
when they make decisions that enhance the MNC’s value.
EXAMPLE When Seattle Co. (from the previous example) recognized the agency problems with its Singapore subsidiary,
it created incentives for the managers of the subsidiary that aligned with the parent’s goal of maximizing
shareholder wealth. Specifically, it set up a compensation system whereby each manager’s annual bonus is
based on the subsidiary’s earnings. This encouraged the managers to reduce expenses so that the subsidiary
would generate higher earnings and they would, in turn, receive a bonus. ●
Corporate Control of Agency Problems In some cases, agency problems can

occur because the goals of the entire management of the MNC are not focused on maxi-
mizing shareholder wealth. Various forms of corporate control can help prevent these
agency problems and induce managers to make decisions that satisfy the MNC’s
shareholders. 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. Such investors may also band together to
demand changes in an MNC, as they know that the firm would not want to lose all of its
major shareholders.
How SOX Improved Corporate Governance of MNCs One limitation of the

corporate control process is that investors rely on reports by the firm’s own managers for
information. If managers are serving themselves rather than the investors, they may exag-
gerate their performance. Many well-known examples (such as Enron and WorldCom) can
be cited of large MNCs that were able to alter their financial reporting and hide problems
from investors.
Enacted in 2002, the Sarbanes-Oxley Act (SOX) ensures a more transparent process for
managers to report on the productivity and financial condition of their firm. It requires
firms to implement an internal reporting process that can be easily monitored by execu-
tives and the board of directors. Methods used by MNCs to improve their internal control
process may include the following:
■ Establishing a centralized database of information
■ Ensuring that all data are reported consistently among subsidiaries
■ Implementing a system that automatically checks data for unusual discrepancies
relative to norms
■ Speeding the process by which all departments and subsidiaries access needed data
■ Making executives more accountable for financial statements by personally
verifying their accuracy
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 infor-
mation for existing and prospective investors.
1-1c Management Structure of an MNC

The magnitude of agency costs can vary with the MNC’s management style. A centralized
management style, as illustrated in the top section of Exhibit 1.1, can reduce agency costs
because it allows managers of the parent to control foreign subsidiaries, which in turn
reduces the power of subsidiary managers. However, the parent’s managers may make poor
decisions for the subsidiary if they are less informed than the subsidiary’s managers about
its specific setting and financial characteristics.
Alternatively, an MNC can use a decentralized management style, as illustrated in
the bottom section of Exhibit 1.1. This style is more likely to result in higher agency
costs because subsidiary managers may make decisions that fail to maximize the value
of the entire MNC. Yet this management style gives more control to those managers who
are closer to the subsidiary’s operations and environment. To the extent that subsidiary
managers recognize the goal of maximizing the value of the overall MNC and are com-
pensated in accordance with that goal, the decentralized management style may be more
effective.
Exhibit 1.1 Management Styles of MNCs
Centralized Multinational
Financial Management
Decentralized Multinational
Financial Management
Given the clear trade-offs between centralized and decentralized management styles,
some MNCs attempt to achieve the advantages of both. That is, they allow subsidiary
managers to make the key decisions about their respective operations, but the parent’s
management monitors those decisions to ensure they are in the MNC’s best interests.
1-2 Why MNCs Pursue International Business

Multinational business has generally increased over time. Three commonly held theories
to explain why MNCs are motivated to expand their business internationally are (1) the
theory of comparative advantage, (2) the imperfect markets theory, and (3) the product
cycle theory. These theories overlap to some extent and can complement one another in
developing a rationale for the evolution of international business.
1-2a Theory of Comparative Advantage

Specialization by countries can increase production efficiency. Some countries, such as
Japan and the United States, have a technology advantage, whereas others, such as China
and Malaysia, have an advantage in the cost of basic labor. Because these advantages cannot
easily be transported, countries tend to use their advantages to specialize in the produc-
tion of goods that can be produced with relative efficiency. This explains why countries
such as Japan and the United States are large producers of electronic products, whereas
countries such as Jamaica and Mexico are large producers of agricultural and handmade
goods. Multinational corporations such as Oracle, Intel, and IBM have grown substantially
in foreign countries because of their technology advantage.
A country that specializes in some products may not produce other products, so
trade between countries is essential. This is the argument made by the classical theory of
comparative advantage. Comparative advantages allow firms to penetrate foreign markets.
Many of the Virgin Islands, for example, specialize in tourism and rely completely on inter-
national 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.
1-2b Imperfect Markets Theory

If each country’s markets were closed to all other countries, then there would be no
international business. At the other extreme, if markets were perfect, such that the factors of
production (such as labor) were easily transferable, then labor and other resources would flow
wherever they were in demand. Such unrestricted mobility of factors would create equality
in both costs and returns, thereby eliminating the comparative cost advantage, which is
the rationale for international trade and investment. However, the real world suffers from
imperfect market conditions where factors of production are somewhat immobile. Costs and
often other restrictions affect the transfer of labor and other resources used for production.
In addition, restrictions may be placed on transferring funds and other resources among
countries. Because markets for the various resources used in production are “imperfect,”
MNCs such as the Gap and Nike often capitalize on a foreign country’s particular resources
by having many of their products manufactured in countries where labor costs are low.
Imperfect markets provide an incentive for firms to seek out foreign opportunities.
1-2c Product Cycle Theory

One of the more popular explanations as to why firms evolve into MNCs is the
product cycle theory. According to this theory, a firm first becomes established in its home
market, where information about markets and competition is more readily available. To
the extent that the 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. As time passes, if the firm’s product becomes very popular in foreign countries,
it may produce the product in foreign markets, thereby reducing its transportation costs.
The firm may also develop strategies to prolong the foreign demand for its product.
One frequently used approach is to differentiate the product so that competitors cannot
duplicate it exactly.
These phases of the product cycle are illustrated in Exhibit 1.2. For instance, 3M Co. uses
one new product to enter a foreign market, after which it expands the product line there.
Whether the firm’s foreign business diminishes or expands over time will depend on how
successful it is at maintaining some advantage over its competition.
Facebook initially established its business in the United States, but quickly recognized
that its service was desired by consumers in other countries. Today, more than 85 percent
of Facebook users are outside the United States, which has allowed Facebook’s advertising
revenue from foreign countries to increase substantially over time.
Exhibit 1.2 International Product Life Cycle
1 2
4a
or
4b
1-3 Methods to Conduct International Business

Firms use several methods to conduct international business:
■ International trade
■ Licensing
■ Franchising
■ Joint ventures
■ Acquisitions of existing operations
■ Establishment of new foreign subsidiaries
In this section, each of these methods is discussed in turn, with particular attention paid
to the respective risk and return characteristics.
WEB 1-3a International Trade

www.trade.gov/mas/ian International trade is a relatively conservative approach that can be used by firms to
Outlook of international penetrate markets (by exporting) or to obtain supplies at a low cost (by importing). This
trade conditions approach entails minimal risk because the firm does not place any of its capital at risk.
for each of several If the firm experiences a decline in its exporting or importing, it can usually reduce or
industries. discontinue that part of its business at a low cost.
Many large U.S.-based MNCs, including Boeing, DowDuPont, General Electric, and
IBM, generate more than $4 billion in annual sales from exporting. Nonetheless, small
businesses account for more than 20 percent of the value of all U.S. exports.
1-3b Licensing
Licensing is an arrangement whereby one firm provides its technology (copyrights, patents,
trademarks, or trade names) in exchange for fees or other considerations. Many producers
of software allow foreign companies to use their software for a fee. In this way, they can
generate revenue from foreign countries without establishing any production plants in
foreign countries or transporting goods to foreign countries.
1-3c Franchising
Under a franchising arrangement, one firm provides a specialized sales or service strategy,
support assistance, and possibly an initial investment in the franchise in exchange for periodic
fees, allowing local residents to own and manage the specific units. For example, 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 as 20 years), but the franchisee must follow standards set by
McDonald’s when operating the business. Because franchising by an MNC often requires a
direct investment in foreign operations, it is referred to as a direct foreign investment (DFI).
1-3d Joint Ventures

A joint venture is a business that is jointly owned and operated by two or more firms.
Many firms enter foreign markets by engaging in a joint venture with firms that are
already established in those markets. Most joint ventures allow two firms to apply their
respective comparative advantages in a given project. These ventures often require some
degree of DFI, while the other parties involved in the joint ventures also participate in the
investment.
For instance, General Mills joined in a venture with Nestlé SA so that the cereals
produced by General Mills could be sold through the overseas sales distribution network
established by Nestlé. 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. Kellogg Co. and Wilmar International Ltd. (based in Singapore)
have established a joint venture to manufacture and distribute cereals and snack products
in China. Wilmar already has a wholly owned subsidiary in China, and that subsidiary
is participating in the venture. Joint ventures between automobile manufacturers are
numerous because each manufacturer can offer its own technological advantages. General
Motors, for example, has ongoing joint ventures with automobile manufacturers in several
different countries.
1-3e Acquisitions of Existing Operations

Firms frequently acquire other firms in foreign countries as a means of penetrating foreign
markets. Such acquisitions give firms full control over their foreign businesses and enable
the MNC to quickly obtain a large portion of foreign market share. Acquisitions represent
DFI because MNCs directly invest in a foreign country by purchasing the operations of
target companies.
EXAMPLE Alphabet, the parent of Google, has made major international acquisitions to expand its business and improve
its technology. It has acquired businesses in Australia (search engines), Brazil (search engines), Canada
(mobile browser), China (search engines), Finland (micro-blogging), Germany (mobile software), Russia
(online advertising), South Korea (weblog software), Spain (photo sharing), Sweden (videoconferencing),
India (artificial intelligence), Belarus (computer vision), and the United Kingdom (graphics processing unit
reliability). ●
Sometimes, however, the acquisition of an existing corporation may lead to large losses
because of the large investment required. In addition, if the foreign operations perform
poorly, it may be difficult to sell them to another company at a reasonable price.
Some firms engage in partial international acquisitions as a means of obtaining a
toehold or stake in foreign operations. On the one hand, this approach requires a smaller
investment than that needed for a full international acquisition, which limits the potential
loss to the firm if the project fails On the other hand, the firm will not have complete
control over foreign operations that are only partially acquired.
1-3f Establishment of New Foreign Subsidiaries

Firms can also penetrate foreign markets by establishing new operations in foreign
countries to produce and sell their products. Like a foreign acquisition, this method
requires a large DFI. Establishing new subsidiaries may be preferred to foreign acquisi-
tions because the operations can be tailored exactly to the firm’s needs. In addition, a
smaller investment may be required than would be needed to purchase existing operations.
However, the firm will not reap any rewards from the investment until the subsidiary is
built and a customer base established.
1-3g Summary of Methods

The methods of increasing international business extend from the relatively simple
approach of international trade to the more complex approach of acquiring foreign firms
or establishing new subsidiaries. International trade and licensing are usually not viewed
as examples of DFI because they do not involve direct investment in foreign operations.
Franchising and joint ventures tend to require some investment in foreign operations but
only to a limited degree. Foreign acquisitions and the establishment of new foreign sub-
sidiaries require substantial investment in foreign operations and account for the largest
portion of DFI.
Many MNCs use a combination of these methods to increase international business.
For example, IBM and PepsiCo engage in substantial direct foreign investment, yet also
derive some of their foreign revenue from various licensing agreements, which require less
DFI to generate revenue.
EXAMPLE The evolution of Nike began in 1962 when Phil Knight, a student at Stanford’s business school, wrote a
paper on how a U.S. firm could use Japanese technology to break the German dominance of the athletic
shoe industry in the United States. After graduation, Knight visited the Unitsuka Tiger shoe company in
Japan. He made a licensing agreement with that company to produce a shoe that he sold in the United
States under the name Blue Ribbon Sports (BRS). In 1972, Knight exported his shoes to Canada. In 1974, he
expanded his operations into Australia. In 1977, the firm licensed factories in Taiwan and Korea to produce
athletic shoes and then sold the shoes in Asian countries. In 1978, BRS became Nike, Inc., and began to
export shoes to Europe and South America. As a result of its exporting and its DFI, Nike’s international
sales reached $1 billion by 1992 and now account for 55 percent of its revenue, amounting to more than
$18 billion per year. ●
Exhibit 1.3 illustrates the effects of international business on an MNC’s cash flows. In
general, the cash outflows associated with international business by the U.S. parent are
used to pay for imports, to comply with its international arrangements, and/or to support
the creation or expansion of foreign subsidiaries. At the same time, an MNC receives cash
flows in the form of payment for its exports, fees for the services it provides within interna-
tional arrangements, and remitted funds from the foreign subsidiaries. The first diagram
in this exhibit illustrates the case in which an MNC engages in international trade; its
international cash flows result either from paying for imported supplies or from receiving
payment in exchange for products that it exports.
The second diagram illustrates the case in which an MNC engages in some interna-
tional arrangements, such as international licensing, franchising, or joint ventures. Any
such arrangement may require the MNC to have cash outflows in foreign countries to
cover, for example, the expenses associated with transferring technology or funding par-
tial investment in a franchise or joint venture. These arrangements generate cash flows
for the MNC in the form of fees for services (for example, technology, support assistance)
that it provides.
The third diagram in Exhibit 1.3 illustrates the case of an MNC that engages in direct
foreign investment. This type of MNC has one or more foreign subsidiaries. Cash out-
flows from the U.S. parent to its foreign subsidiaries may take the form of invested funds
to help finance the operations of the foreign subsidiaries. In addition, cash flows from the
foreign subsidiaries to the U.S. parent occur in the form of remitted earnings and fees for
services provided by the parent; all of these flows can be classified as remitted funds from
the foreign subsidiaries.
Exhibit 1.3 Cash Flow Diagrams for MNCs
International Trade by the MNC
Cash Inflows from Exporting
Cash Outflows to Pay for Importing
Licensing, Franchising, Joint Ventures by the MNC
Cash Inflows from Services Provided
Cash Outflows for Services Received
Investment in Foreign Subsidiaries by the MNC
Cash Inflows from Remitted Earnings
Cash Outflows to Finance the Operations
1-4 Valuation Model for an MNC

The value of an MNC is relevant to its shareholders and its debt holders. When managers
make decisions that maximize the firm’s value, they also maximize shareholder wealth.
Given that international financial management should be conducted with the goal of
increasing the MNC’s value, it is useful to review some basics of valuation and identify the
key factors that affect an MNC’s value over time.
1-4a Domestic Valuation Model

Before modeling an MNC’s value, consider the valuation of a purely domestic firm in the
United States that does not engage in any foreign transactions. The value (V ) of the purely
domestic firm is commonly specified as the present value of its expected dollar cash flows:
n  E CF 

V 5 ∑
$, t
t 
t 51  1 1 k 

where E(CF$,t ) denotes expected cash flows to be received at the end of period t; n is
the number of future periods in which cash flows are received; and k represents not only
the weighted average cost of capital, but also the required rate of return by investors and
creditors that provide funds to the MNC.
Dollar Cash Flows The dollar cash flows in period t comprise funds received by the
firm minus funds needed to pay expenses or taxes or to reinvest in the firm (such as an
investment to replace old computers or machinery). The expected cash flows are estimated
from knowledge about existing projects as well as other projects that will be implemented
in the future. A firm’s decisions about how it should invest funds to expand its business
can affect its expected future cash flows, which in turn can affect the firm’s value. Holding
other factors constant, an increase in expected cash flows over time should increase the
value of a firm.
Cost of Capital The required rate of return (k ) in the denominator of the valuation
equation represents the cost of capital (including both the cost of debt and the cost of
equity) to the firm and is, in essence, a weighted average of the cost of capital based on all of
the firm’s projects. In making decisions that affect its cost of debt or equity for one or more
projects, the firm also influences the weighted average of its cost of capital and, therefore,
the required rate of return. If the firm’s credit rating is suddenly lowered, for example, then
its cost of capital will probably increase, and so will its required rate of return. Holding
other factors constant, an increase in the firm’s required rate of return will reduce the
value of the firm because expected cash flows must be discounted at a higher interest rate.
Conversely, a decrease in the firm’s required rate of return will increase the value of the
firm because expected cash flows will be discounted at a lower required rate of return.
1-4b Multinational Valuation Model

An MNC’s value can be specified in the same manner as a purely domestic firm’s value.
Managers must consider a new factor, however: The expected cash flows generated by a
U.S.-based MNC’s parent in period t may be coming from various countries and may be
denominated in different foreign currencies.
In this case, the foreign currency cash flows will be converted into dollars. The
expected dollar cash flows to be received at the end of period t are then equal to the sum
of the products of cash flows denominated in each currency j multiplied by the expected
exchange rate at which currency j could be converted into dollar cash flows by the MNC
at the end of period t:
m
E CF$,t 5 ∑ E CFj ,t 3 E S j ,t 
j 51
 
where CFj ,t represents the amount of cash flow denominated in a particular foreign
currency j at the end of period t, and S j ,t denotes the exchange rate at which the foreign
currency (measured in dollars per unit of the foreign currency) can be converted to dollars
at the end of period t.
Dollar Cash Flows of an MNC That Uses Two Currencies An MNC that
does business in two currencies 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 could be converted to dollars and then summing those two products.
Consider an MNC’s business transactions as a portfolio of currency cash flows, with
one set of cash flows for each currency in which it conducts business. The expected dollar
cash flows derived from each of those currencies can be combined to determine the total
expected dollar cash flows in the given period. It is easier to derive an expected dollar cash
flow value for each currency before combining the cash flows among currencies within a
given period, because each currency’s cash flow amount must be converted to a common
unit (the dollar) before combining the amounts.
EXAMPLE Carolina Co. expects cash flows of $100,000 from its local business and 1 million Mexican pesos from its busi-
ness in Mexico at the end of period t. Assuming that the peso’s value is expected to be $.09 when converted
into dollars, the expected dollar cash flows are:
m
E CF$,t 5 ∑ E CFj ,t 3 E S j ,t 
j 51
 
5 $ CF from U.S. operations 1 $ CF from operations in Mexico
5 $100, 000 1  1,000,000 pesos 3 $.09 
5 $100,000 1 $90,000
5 $190,000
The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars, so they did not
need to be converted. ●
Dollar Cash Flows of an MNC That Uses Multiple Currencies The same
process just described can be employed to estimate the dollar cash flows an MNC that
does business in many foreign currencies. The general formula for estimating the dollar
cash flows to be received by an MNC from multiple currencies in one period can be written
as follows:
m
E CF$,t 5 ∑ E CFj ,t 3 E S j ,t 
j 51
 
EXAMPLE Assume that Yale Co. will receive cash in 15 different countries at the end of the next period. To estimate
the value of Yale Co., the first step is to estimate the amount of cash flows that it will receive at the end of
the period in each currency (such as 2 million euros, 8 million Mexican pesos, and so on). Second, obtain a
forecast of the currency’s exchange rate for cash flows that will arrive at the end of the period for each of the
15 currencies (such as euro forecast 5 $1.40, peso forecast 5 $.12, and so on). The existing exchange rate can
be used as a forecast for the future exchange rate, although many alternative methods are also possible (as
explained in Chapter 9). Third, multiply the amount of each foreign currency to be received by the forecasted
exchange rate of that currency to estimate the dollar cash flows to be received due to each currency. Fourth,
add the estimated dollar cash flows for all 15 currencies to determine the total expected dollar cash flows in
the period. The previous equation captures the four steps just described. When applying that equation to
this example, m 5 15 because there are 15 different currencies. ●
Valuation of an MNC’s Cash Flows over Multiple Periods The process of

estimating dollar cash flows for a single period can be adapted to account for multiple
periods. First, apply the same process described for a single period to all future periods
in which the MNC will receive cash flows; this will generate an estimate of total dollar
cash f lows to be received in every period in the future. Second, discount the estimated
total dollar cash flow for each period at the weighted cost of capital (k ). Third, add these
discounted cash flows to estimate the value of this MNC.
The process for valuing an MNC receiving multiple currencies over multiple periods
can be expressed formally as follows:
m  
n ∑ 
E CFj ,t 3 E S j ,t  
 j 51  
V 5 ∑ t 
t 51  11k 
 
where CFj ,t is the cash flow denominated in a particular currency (which may be dollars)
and S j ,t denotes the exchange rate at which the MNC can convert the foreign currency to
the domestic currency at the end of period t. Whereas the previous equation is applied to
single-period cash flows, this equation considers cash flows over multiple periods and then
discounts those flows to obtain a present value.
Because the management of an MNC should focus on maximizing its value, the equation
for valuing an MNC is extremely important. According to this equation, the value (V ) will
increase in response to managerial decisions that increase the amount of its cash flows in
a particular currency (CFj ) or to conditions that increase the exchange rate at which that
currency is converted into dollars (S j ).
To avoid double counting, cash flows of the MNC’s subsidiaries are considered in the
valuation model only when they reflect transactions with the U.S. parent. Therefore, any
expected cash flows received by foreign subsidiaries should not be counted in the valuation
equation until they are remitted to the parent.
The denominator of the valuation model for the MNC remains unchanged from the
original valuation model for the purely domestic firm. However, note that the weighted
average cost of capital for the MNC is based on funding some projects involving business
in different countries. In consequence, any decision by the MNC’s parent that affects the
cost of its capital for supporting projects in a specific country will also affect its weighted
average cost of capital (and required rate of return) and, therefore, its value.
EXAMPLE Austin Co. is a U.S.-based MNC that sells video games to U.S. consumers; it also has European subsidiaries
that produce and sell the games in Europe. Last year, Austin received $40 million in cash flows from its
U.S. operations and 20 million euros from its European operations. The euro was valued at $1.30 when the
European cash flows were converted to dollars and remitted to the U.S parent, so Austin’s cash flows last
year are calculated as follows:
Austin’s total
$ cash flows last year 5 $ cash flows from U.S. operations 1 $ cash flows from foreign operations
5 $ cash flows from U.S. operations 1 [(euro cash flows) 3 (euro exchange rate)]
5 $40,000,000 1 [(20,000,000 euros) 3 ($1.30)]
5 $40,000,000 1 $26,000,000
5 $66,000,000
Assume that Austin Co. plans to maintain its business operations in the same way in the United States
and Europe for the next three years. As a basic valuation model, the firm could use last year’s cash flows
to estimate each future year’s cash flows; then its expected cash flows would be $66 million for each
of the next three years. Its valuation could be estimated by discounting these cash flows at its cost of
capital. ●
1-4c Uncertainty Surrounding an MNC’s Cash Flows

The MNC’s future cash flows (and therefore its valuation) are subject to uncertainty
because of its exposure not only to domestic economic conditions but also to interna-
tional economic conditions, political conditions, and exchange rate risk. These factors are
explained next, and Exhibit 1.4 complements the discussion.
Exposure to International Economic Conditions To the extent that a foreign
country’s economic conditions affect an MNC’s cash flows, they also affect the MNC’s
valuation. The cash inflows that an MNC receives from sales in a foreign country during a
given period depend on the demand by that country’s consumers for the MNC’s products,
which in turn is affected by that country’s national income in that period. If economic con-
ditions improve in that country, consumers there may enjoy an increase in their income
and the employment rate may rise. In that case, those consumers will have more money to
spend, and their demand for the MNC’s products will increase.
Conversely, an MNC can be adversely affected by its exposure to declining interna-
tional economic conditions. If conditions weaken in the foreign country where the MNC
does business, that country’s consumers may suffer a decrease in their income and the
employment rate may decline. Those consumers will then have less money to spend, and
their demand for the MNC’s products will decrease. In this case, the MNC’s cash flows are
reduced because of its exposure to the harsher international economic conditions.
International economic conditions can also affect the MNC’s cash flows indirectly by
affecting its home economy. When a country’s economy strengthens and, in turn, its con-
sumers buy more products from other countries, the firms in those other countries will
experience stronger sales and cash flows. Conversely, if the foreign country’s economy
weakens and its consumers buy fewer products from other countries, then the firms in
those countries will experience weaker sales and cash flows.
Exhibit 1.4 How an MNC’s Valuation Is Exposed to Uncertainty (Risk)
Uncertain foreign currency cash flows

due to uncertain foreign economic Uncertainty surrounding
and political conditions future exchange rates
n S [E(CF
j51
j,t ) 3 E (Sj,t )]
V5S
t51 (1 1 k )t
Uncertainty Surrounding an MNC’s Valuation:
Exposure to Foreign Economies: If [CFj,t , E (CFj,t )] V

Exposure to Political Risk: If [CFj,t , E (CFj,t )] V
Exposure to Exchange Rate Risk: If [Sj,t , E (Sj,t )] V
Exhibit 1.5 Potential Effects of International Economic Conditions
The effects on international economic conditions are illustrated in Exhibit 1.5, which
shows the different ways in which weak European conditions can affect the valuations of
U.S.-based MNCs. The string of effects (from left to right) in this exhibit indicates how
weak European economic conditions cause a decline in the demand for the products made
by U.S. firms. The result is weaker cash flows of the U.S.-based MNCs that sell products
either as exports or through their European subsidiaries to European customers. In addi-
tion, the weak European economy can weaken the U.S. economy, resulting in a lower
U.S. demand for products produced by U.S.-based MNCs and domestic U.S. firms.
EXAMPLE Recall from the previous example that Austin Co. expects annual cash flows of $40 million from its U.S. opera-
tions. If Europe experiences a recession, however, Austin expects European demand for many U.S. products
to be reduced, which will adversely affect the U.S. economy. Under these conditions, the U.S. demand for
Austin’s video games would decline, reducing its expected annual cash flows from its U.S. operations from
$40 million to $38 million. A European recession would naturally result in reduced European demand for
Austin’s video games, so the company also reduces its expected euro cash flows from its European operations
from 20 million euros to 16 million euros. ●
Exposure to International Political Risk Political risk in any country can affect
the level of an MNC’s sales. A foreign government may increase taxes or impose barriers on
the MNC’s subsidiary. Alternatively, consumers in a foreign country may boycott the MNC
if friction arises between the government of their country and the MNC’s home country.
These kinds of political actions can, in turn, reduce the cash flows of an MNC. The term
“country risk” is commonly used to reflect an MNC’s exposure to a variety of country
conditions, including political actions such as friction within the government, government
policies (such as tax rules), and financial conditions within that country.
EXAMPLE From time to time, the United States imposes sanctions on Russia for political reasons, and in retaliation Russia
bans various food items that were previously imported from the United States. The ban by Russia reduces
the sales and cash flows of some U.S.-based MNCs that had previously exported to Russia. Those MNCs
have nothing to do with the sanctions imposed on Russia, yet they can be adversely affected by the political
friction between the United States and Russia. ●
Exposure to Exchange Rate Risk If the foreign currencies to be received by a

U.S.-based MNC suddenly weaken against the dollar, then the MNC will receive a lower
amount of dollar cash flows than expected. Therefore, the MNC’s cash flows will be
reduced.
EXAMPLE As described in the previous example, Austin Co. now anticipates a European recession and so has revised
its expected annual cash flows from its European operations to be 16 million euros. The dollar cash flows
that Austin will receive from these euro cash flows depend on the exchange rate at the time that those euros
are converted to dollars. If the exchange rate is expected to be $1.30, then Austin will have the following
cash flows:
Austin’s $ cash flows resulting

from European operations 5 Austin’s cash flows in euros 3 euro exchange rate
5 16,000,000 euros 3 $1.30
5 $20,800,000
If Austin believes that the anticipated European recession will cause the euro’s value to weaken and be
worth only $1.20 when the euros are converted into dollars, then its estimate of the dollar cash flows from
European operations would be revised as follows:
Austin’s $ cash flows resulting

from European operations 5 Austin’s cash flows in euros 3 euro exchange rate
5 16,000,000 euros 3 $1.20
5 $19,200,000
Thus, Austin’s expected dollar cash flows are reduced as a result of the decrease in the expected value of
the euro at the time of conversion into dollars. ●
This conceptual framework can be used to understand how MNCs such as Facebook
and Alphabet (Google) are affected by exchange rate movements. Alphabet now receives
more than half of its total revenue from outside the United States, from markets where it
provides advertising for non-U.S. companies targeted at non-U.S. users. Consequently, its
dollar cash flows are favorably affected when the currencies it receives appreciate against
the dollar over time.
As Facebook’s international business continues to grow, its estimated dollar cash flows
in any period will become more sensitive to the exchange rates of the currencies in which its
foreign currency cash flows are denominated. If the revenue it receives is denominated in
currencies that appreciate against the dollar over time, then its dollar cash flows and valu-
ation will increase. Conversely, if the revenue it receives is denominated in currencies that
depreciate against the dollar over time, its dollar cash flows and valuation will decrease.
Many MNCs have cash outflows in one or more foreign currencies because they import
supplies or materials from companies in other countries. When an MNC anticipates future
cash outflows in foreign currencies, it is exposed to exchange rate movements, but in the
opposite direction. That is, if those foreign currencies strengthen, then the MNC will need
more dollars to obtain the foreign currencies to make its payments.
1-4d How Uncertainty Affects the MNC’s Cost of Capital

If there is suddenly more uncertainty about an MNC’s future cash flows, then investors
would require a higher expected rate of return, which increases the MNC’s cost of obtain-
ing capital and lowers its valuation.
EXAMPLE Because Austin Co. does substantial business in Europe, its value is strongly influenced by how much revenue
it expects to earn from that business. As a result of some events that occurred in Europe today, economic
conditions in Europe are subject to considerable uncertainty. Although Austin does not change its forecasts
of expected cash flows, it is concerned that the actual flows could deviate substantially from those forecasts.
The increased uncertainty surrounding these cash flows will increase the firm’s cost of capital, because
its investors will now require a higher rate of return. In other words, although the numerator (estimated
cash flows) of the valuation equation has not changed, the denominator has increased due to the increased
uncertainty surrounding the cash flows. As a consequence, the valuation of Austin Co. decreases. ●
If the uncertainty surrounding economic conditions that influence cash flows declines,
the uncertainty surrounding cash flows of MNCs also declines and results in a lower
required rate of return and cost of capital for MNCs. Consequently, the valuations of MNCs
increase.
1-5 Organization of the Text

The chapters in this textbook are organized as shown in Exhibit 1.6. Chapters 2 through 8
discuss international markets and conditions from a macroeconomic perspective, focus-
ing on external forces that can affect the value of an MNC. Although financial managers
Exhibit 1.6 Organization of Chapters

cannot control such forces, they can control the extent of their firm’s exposure to them.
These chapters focus on macroeconomic concepts that serve as a foundation for interna-
tional financial management.
Chapters 9 through 21 take a microeconomic perspective and focus on how the financial
management of an MNC can affect its value. Financial decisions by MNCs are commonly
classified as either investing decisions or financing decisions. In general, investing deci-
sions by an MNC tend to affect the numerator of the valuation model because such deci-
sions affect expected cash flows. In addition, investing decisions by the MNC that alter the
firm’s weighted average cost of capital may affect the denominator of the valuation model.
Long-term financing decisions by an MNC tend to affect the denominator of the valuation
model because they affect its cost of capital.
SUMMARY
■ The main goal of an MNC is to maximize share- home countries, they commonly expand their
holder wealth. When managers are tempted to serve product specialization in foreign countries.
their own interests instead of those of shareholders, ■ The most common methods by which firms conduct
an agency problem exists. Multinational corporations international business are international trade, licens-
tend to experience greater agency problems than do ing, franchising, joint ventures, acquisitions of foreign
domestic firms because managers of foreign subsid- firms, and formation of foreign subsidiaries. Methods
iaries might be tempted to make decisions that serve such as licensing and franchising involve little capital
their subsidiaries instead of the overall MNC. Proper investment but distribute some of the profits to other
incentives and consistent communication from the parties. The acquisition of foreign firms and the forma-
parent may help to ensure that subsidiary managers tion of foreign subsidiaries require substantial capital
focus on serving the overall MNC. investments but offer the potential for large returns.
■ International business is encouraged by three key ■ The valuation model of an MNC shows that the MNC’s
theories. The theory of comparative advantage sug- value is favorably affected when its expected foreign
gests that each country should use its comparative cash inflows increase, the currencies denominating
advantage to specialize in its area of production and those cash inflows increase, or the MNC’s required
rely on other countries to meet other needs. The rate of return decreases. Conversely, the MNC’s value
imperfect markets theory suggests that imperfect is adversely affected when its expected foreign cash
markets render the factors of production immobile, inflows decrease, the values of currencies denomi-
which encourages countries to specialize based on nating those cash flows decrease (assuming that the
the resources they have. The product cycle theory MNC has net cash inflows in foreign currencies), or
suggests that, after firms are established in their the MNC’s required rate of return increases.
POINT/COUNTERPOINT
Should an MNC Reduce Its Ethical Standards to Compete Internationally?
Point Yes. When a U.S.-based MNC competes skybox tickets to sporting events; this practice is
in some countries, it may encounter some business no different than making a payoff. If the payoffs
norms there that are not allowed in the United are bigger in some foreign countries, the MNC can
States. For example, when competing for a govern- compete only by matching the payoffs provided by
ment contract, firms might provide payoffs to the its competitors.
government officials who will make the decision. Counterpoint No. A U.S.-based MNC should
Yet in the United States, a firm will sometimes maintain a standard code of ethics that applies to any
take a client on an expensive golf outing or provide country, even if it is at a disadvantage in a foreign
country that allows activities that might be viewed Who Is Correct? Use the Internet to learn more
as unethical. In this way, the MNC establishes more about this issue. Which argument do you support?
credibility worldwide. Offer your own opinion on this issue.
SELF-TEST
Answers are provided in Appendix A at the back of the 2. Explain why unfavorable economic or political
text. conditions affect the MNC’s cash flows, required rate
1. What are typical reasons why MNCs expand of return, and valuation.
internationally? 3. Identify the more obvious risks faced by MNCs
that expand internationally.
QUESTIONS AND APPLICATIONS

1. Agency Problems of MNCs b. Why might the Internet have resulted in more
a. Explain the agency problem of MNCs. international business?
b. Why might agency costs be larger for an MNC 6. Impact of Exchange Rate Movements
than for a purely domestic firm? Plak Co. of Chicago has several European
subsidiaries that remit earnings to it each year.
2. Comparative Advantage
Explain how appreciation of the euro (the currency
a. Explain how the theory of comparative advantage used in many European countries) would affect
relates to the need for international business. Plak’s valuation.
b. Explain how the product cycle theory relates to 7. Benefits and Risks of International
the growth of an MNC. Business As an overall review of this chapter,
3. Imperfect Markets identify possible reasons for growth in international
a. Explain how the existence of imperfect markets business. Then list the various disadvantages that may
has led to the establishment of subsidiaries in foreign discourage international business.
markets. 8. Valuation of an MNC Hudson Co., a U.S.
b. If perfect markets existed, would wages, prices, firm, has a subsidiary in Mexico, where political risk
and interest rates among countries be more similar has recently increased. Hudson’s best guess of its
or less similar than under conditions of imperfect future peso cash flows to be received has not changed.
markets? Why? However, its valuation has declined as a result of the
increase in political risk. Explain.
4. International Opportunities
9. Centralization and Agency Costs Would
a. Do you think the acquisition of a foreign firm or
the agency problem be more pronounced for Berkeley
licensing will result in greater growth for an MNC?
Corp., whose parent company makes most major
Which alternative is likely to have more risk?
decisions for its foreign subsidiaries, or Oakland
b. Describe a scenario in which the size of a Corp., which uses a decentralized approach?
corporation is not affected by access to international
10. Global Competition Explain why more-
opportunities.
standardized product specifications across countries
c. Explain why MNCs such as Coca-Cola and can increase global competition.
PepsiCo still have numerous opportunities for
11. Exposure to Exchange Rates McCanna
international expansion.
Corp., a U.S. firm, has a French subsidiary that
5. International Opportunities Due to the produces and exports wine. All of the European
Internet countries where it sells its wine use the euro as their
a. What factors cause some firms to become more currency, which is the same currency used in France.
internationalized than others? Is McCanna Corp. exposed to exchange rate risk?
12. Macro versus Micro Topics Review this foreign competition. What barrier in Japan did
book’s table of contents and indicate whether each of Anheuser-Busch circumvent as a result of the joint
the chapters from Chapter 2 through Chapter 21 has a venture? What barrier in the United States did Kirin
macro or micro perspective. circumvent as a result of the joint venture?
13. Methods Used to Conduct International d. Explain how Anheuser-Busch could have lost
Business Duve, Inc., desires to penetrate a foreign some of its market share in countries outside Japan as
market either by creating a licensing agreement with a result of this particular joint venture.
a foreign firm or by acquiring a foreign firm. Explain 18. Impact of Eastern European Growth The
the differences in potential risk and return between managers of Loyola Corp. recently had a meeting to
a licensing agreement with a foreign firm and the discuss new opportunities in Europe as a result of
acquisition of a foreign firm. recent integration among Eastern European countries.
14. International Business Methods Snyder They decided not to penetrate new markets because of
Golf Co., a U.S. firm that sells high-quality golf clubs their present focus on expanding market share in the
in the United States, wants to expand internationally United States. Loyola’s financial managers have deve-
by selling the same golf clubs in Brazil. loped forecasts for earnings based on the 12 percent
a. Describe the trade-offs that are involved for each market share (defined here as its percentage of total
method (such as exporting, direct foreign investment, European sales) that Loyola currently has in Eastern
and so on) that Snyder could use to achieve its goal. Europe. Is 12 percent an appropriate estimate for next
year’s Eastern European market share? If not, does
b. Which method would you recommend for this it likely overestimate or underestimate the actual
firm? Justify your recommendation. Eastern European market share next year?
15. Impact of Political Risk Explain why
19. Valuation of an MNC Birm Co., based
political risk may discourage international business.
in Alabama, is considering several international
16. Impact of 9/11 Following the terrorist attacks opportunities in Europe that could affect the
on the United States on September 11, 2001, the firm’s value. Its valuation depends on four factors:
valuations of many MNCs declined by more than (1) expected cash flows in dollars, (2) expected cash
10 percent. Explain why the expected cash flows of flows in euros that are ultimately converted into
MNCs were reduced, even if they were not directly hit dollars, (3) the rate at which it can convert euros
by the terrorist attacks. to dollars, and (4) Birm’s weighted average cost of
capital. For each of the following opportunities,
Advanced Questions identify which factors will be affected.
17. International Joint Venture Anheuser-Busch a. Birm plans a licensing deal in which it will sell
(which is now part of AB InBev due to a merger), the technology to a firm in Germany for $3 million; the
producer of Budweiser and other beers, has engaged in payment is invoiced in dollars, and this project has the
a joint venture with Kirin Brewery, the largest brewery same risk level as its existing businesses.
in Japan. The joint venture enabled Anheuser-Busch to b. Birm plans to acquire a large firm in Portugal that
have its beer distributed through Kirin’s distribution is riskier than its existing businesses.
channels in Japan. In addition, it could utilize Kirin’s c. Birm plans to discontinue its relationship with a
facilities to produce beer that would be sold locally. In U.S. supplier so that it can import a small amount of
return, Anheuser-Busch provided information about supplies (denominated in euros) at a lower cost from a
the American beer market to Kirin. Belgian supplier.
a. Explain how the joint venture enabled Anheuser- d. Birm plans to export a small amount of materials
Busch to achieve its objective of maximizing to Ireland that are denominated in euros.
shareholder wealth.
20. Assessing Motives for International
b. Explain how the joint venture limited the risk of Business Fort Worth, Inc., specializes in
the international business. manufacturing some basic parts for sports utility
c. Many international joint ventures are intended vehicles (SUVs) that are produced and sold in the
to circumvent barriers that might otherwise prevent United States. Its main advantage in the United
States is that its production is efficient and less costly It just established a subsidiary in Athens, Greece,
than that of some other unionized manufacturers. It which provides tour services in the Greek islands for
has a substantial market share in the United States. American visitors. This subsidiary rented a shop near
Its manufacturing process is labor intensive. The the port of Athens. It also hired residents of Athens
company pays relatively low wages compared to its who could speak English and provide tours of the
U.S. competitors, but has guaranteed the local workers Greek islands. The subsidiary’s main costs are rent
that their positions will not be eliminated for the next and salaries for its employees and the lease of a few
30 years. It hired a consultant to determine whether it large boats in Athens that it uses for tours. American
should set up a subsidiary in Mexico, where the parts tourists pay for the entire tour in dollars at Nantucket’s
would be produced. The consultant suggested that main U.S. office before they depart for Greece.
Fort Worth should expand for the following reasons. a. Explain why Nantucket may be able to effectively
Offer your opinion on whether the consultant’s capitalize on international opportunities such as the
reasons are logical. Greek island tours.
a. Theory of competitive advantage: Not many SUVs b. Nantucket is privately owned by owners who
are sold in Mexico, so Fort Worth would not have to reside in the United States and work in the main
face much competition there. office. Explain possible agency problems associated
b. Imperfect markets theory: Fort Worth cannot with the creation of a subsidiary in Athens, Greece.
easily transfer workers to Mexico, but it can establish How can Nantucket attempt to reduce these agency
a subsidiary there that it can use to penetrate a new costs?
market. c. Greece’s cost of labor and rent are relatively
c. Product cycle theory: Fort Worth has been successful low. Explain why this information is relevant to
in the United States. It has limited growth opportunities Nantucket’s decision to establish a tour business in
because it already controls much of the U.S. market for Greece.
the parts it produces. The natural next step is to conduct d. Explain how the cash flow situation of the Greek
the same business in a foreign country. tour business exposes Nantucket to exchange rate risk.
d. Exchange rate risk: The exchange rate of the peso Is Nantucket favorably or unfavorably affected when
has weakened recently, which would allow Fort Worth to the euro (Greece’s currency) appreciates against the
build a plant in Mexico at a very low cost (by exchanging dollar? Explain.
dollars for the cheap pesos to build the plant). e. Nantucket plans to finance its Greek tour busi-
e. Political risk: The political conditions in Mexico ness. Its subsidiary could obtain loans in euros from
have stabilized in the last few months, so Fort Worth a bank in Greece to cover its rent, and its main office
should attempt to penetrate the Mexican market now. could pay off the loans over time. Alternatively, its
21. Valuation of Walmart’s International main office could borrow dollars and then periodi-
Business In addition to its stores in the United cally convert dollars to euros to pay the expenses in
States, Walmart Stores, Inc., has numerous retail units Greece. Does either type of loan reduce the exposure
in Argentina, Brazil, Canada, China, Mexico, and the of Nantucket to exchange rate risk? Explain.
United Kingdom. Consider that the value of Walmart f. Explain how the Greek island tour business could
is composed of two parts: a U.S. part (due to business expose Nantucket to political country risk.
in the United States) and a non-U.S. part (due to 23. Valuation of an MNC Rose Co., a U.S. firm,
business in other countries). Explain how to determine has expanded its business by establishing networking
the present value (in dollars) of the non-U.S. part portals in numerous countries, including Argentina,
assuming that you had access to all the details of Australia, China, Germany, Ireland, Japan, and the
Walmart businesses outside the United States. United Kingdom. It has cash outflows associated with
22. Impact of International Business on the creation and administration of each portal. It also
Cash Flows and Risk Nantucket Travel Agency generates cash inflows from selling advertising space
specializes in tours for American tourists. Until on its website. Each portal results in cash flows in a
recently, all of its business was in the United States. different currency. Thus, the valuation of Rose is based
on its expected future net cash flows in Argentine the uncertainty surrounding the Canadian dollar’s
pesos after converting them into U.S. dollars, its future value over the long term. Explain how this
expected net cash flows in Australian dollars after event might affect the valuation of Minneapolis Co.
converting them into U.S. dollars, and so on. Explain 27. Exposure of MNCs to Exchange Rate
how and why Rose’s valuation would change if most Movements Arlington Co. expects to receive
investors suddenly expected that the dollar would 10 million euros in each of the next 10 years. It will
weaken against most currencies over time. need to obtain 2 million Mexican pesos in each of
24. Uncertainty Surrounding an MNC’s the next 10 years. The euro exchange rate is pres-
Valuation Carlisle Co. is a U.S. firm that is about ently valued at $1.38 and is expected to depreciate by
to purchase a large company in Switzerland at a 2 percent each year over time. The peso is valued at $.13
purchase price of $20 million. This company, which and is expected to depreciate by 2 percent each year
produces furniture and sells it locally (in Switzerland), over time. Review the valuation equation for an MNC.
is expected to earn large profits every year. Following Do you think that the exchange rate movements will
its acquisition, the company will become a subsidiary have a favorable or unfavorable effect on the MNC?
of Carlisle and will periodically remit its excess cash 28. Impact of a Recession on an MNC’s
flows due to its profits to Carlisle Co. Assume that Value If a U.S. recession occurred without any
Carlisle Co. has no other international business. change in interest rates, identify the part of the MNC
Carlisle has $10 million that it will use to pay for part valuation equation that would most likely be affected.
of the Swiss company and will finance the rest of its 29. Exposure of MNCs to Exchange Rate
purchase with borrowed dollars. Carlisle Co. can Movements Because of the low labor costs in
obtain supplies from either a U.S. supplier or a Swiss Thailand, Melnick Co. (based in the United States)
supplier (in which case the payment would be made recently established a major research and development
in Swiss francs). Both suppliers are very reputable subsidiary there that it owns. The subsidiary was
and there would be no exposure to country risk when created to improve new products that Melnick can sell
using either supplier. Is the valuation of the total in the United States (denominated in dollars) to U.S.
cash flows of Carlisle Co. more uncertain if it obtains customers. The subsidiary pays its local employees in
its supplies from a U.S. firm or from a Swiss firm? baht (the Thai currency). The subsidiary has a small
Explain briefly. amount of sales denominated in baht, but its expenses
25. Impact of Exchange Rates on MNC Value are much larger than its revenue. Melnick has just
Olmsted Co. has small computer chips assembled in obtained a large loan denominated in baht that will
Poland and transports the final assembled products be used to expand its subsidiary. The business that
to the parent company; the parent then sells these the parent company conducts in the United States
products in the United States. The assembled is not exposed to exchange rate risk. If the Thai
products are invoiced in dollars. Olmsted Co. uses baht weakens over the next 3 years, will the value
Polish currency (the zloty) to produce these chips of Melnick Co. be favorably affected, unfavorably
and assemble them in Poland. The Polish subsidiary affected, or not affected? Briefly explain.
pays the employees in the local currency (zloty), 30. Shareholder Rights of Investors in MNCs
and Olmsted Co. finances its subsidiary operations MNCs tend to expand more when they can more
with loans from a Polish bank (in zloty). The parent easily access funds by issuing stock. In some countries,
of Olmsted sends sufficient monthly payments (in shareholder rights are very limited, and the MNCs
dollars) to the subsidiary to repay the loan and other have limited ability to raise funds by issuing stock.
expenses incurred by the subsidiary. If the Polish zloty Explain why access to funding is more restricted for
depreciates against the dollar over time, will that have MNCs based in countries where shareholder rights are
a favorable, unfavorable, or neutral effect on the value limited.
of Olmsted Co.? Briefly explain. 31. MNC Cash Flows and Exchange Rate
26. Impact of Uncertainty on MNC Value Risk Tuscaloosa Co. is a U.S. firm that assembles
Minneapolis Co. is a major exporter of products to phones in Argentina and transports the final
Canada. Today, an event occurred that has increased assembled products to the parent, which then sells
the products in the United States. The assembled future value of the Swiss franc is uncertain because
products are invoiced in dollars. The Argentine it fluctuates, your best guess is that the Swiss franc’s
subsidiary obtains some material from China, and value will be $1.10 at the end this year. What are the
the Chinese exporter is willing to accept Argentine expected dollar cash flows of Bangor Co?
pesos as payment for these materials that it exports. b. Assume that Concord Co., a U.S. firm, is in the
The Argentine subsidiary pays its employees in the same industry as Bangor Co. There is no political risk
local currency (pesos), and finances its operations that could have any impact on the cash flows of either
with loans from an Argentine bank (in pesos). firm. Concord Co. knows that it will have cash inflows
Tuscaloosa Co. has no other international business. If of $900,000 from domestic operations, cash inflows
the Argentine peso depreciates against the dollar over of 700,000 Swiss francs due to exports to Swiss opera-
time, will that have a favorable, unfavorable, or neutral tions, and cash outflows of 800,000 Swiss francs at the
effect on Tuscaloosa Co.? Briefly explain. end of the year. Is the valuation of the total cash flows
32. MNC Cash Flows and Exchange Rate of Concord Co. more uncertain or less uncertain than
Risk Asheville Co. has a subsidiary in Mexico that the total cash flows of Bangor Co.? Explain briefly.
develops software for its parent. It rents a large
35. Valuation of an MNC Odessa Co., Midland
facility in Mexico and hires many people in Mexico
Co., and Roswell Co. are U.S. firms in the same indus-
to work in this facility. Asheville Co. has no other
try and have the same valuation as of yesterday, based
international business. All operations are presently
on the present value of the future cash flows of each
funded by the parent company. All the software
company. Odessa Co. obtains a large amount of its
is sold to U.S. firms by the parent company and
supplies invoiced in euros from European countries,
invoiced in U.S. dollars.
and all of its sales are invoiced in dollars. Midland has
a. If the Mexican peso appreciates against the dollar, a large subsidiary in Europe that does all of its business
will this have a favorable effect, unfavorable effect, or in euros and remits profits to the U.S. parent every
no effect on Asheville’s value? year. Roswell Co. has no international business. As of
b. Asheville Co. plans to borrow funds to support its this morning, an event occurred that you believe will
expansion in the United States. The Mexican interest cause a substantial depreciation of the euro against
rates are presently lower than U.S. interest rates, so the dollar over time. Assume that this event will not
Asheville obtains a loan denominated in Mexican pesos change the business operations of the firms mentioned
to support its expansion in the United States. Will the in this question. Which firm will have the highest
borrowing of pesos increase, decrease, or have no effect valuation based on your expectations? Briefly explain.
on its exposure to exchange rate risk? Briefly explain. 36. Impact of Uncertainty on an MNC’s
33. Estimating an MNC’s Cash Flows Biloxi Valuation Assume that Alpine Co. is a U.S. firm that
Co. is a U.S. firm that has a subsidiary in China. The has direct foreign investment in Brazil as a result of
subsidiary reinvests half of its net cash flows into establishing a subsidiary there. Political conditions
operations and remits half to the parent. Biloxi Co. has have changed in Brazil, but investors’ best guesses
expected cash flows from its domestic business equal of the future cash flows per year for Alpine Co. have
to $10 million, and the Chinese subsidiary is expected not changed. Yet there is more uncertainty sur-
to generate 100 million Chinese yuan at the end of the rounding these best guesses of Alpine’s cash flows.
year. The expected value of yuan at the end of the year In other words, the distribution of possible outcomes
is $.13. What are the expected dollar cash flows of the above and below the best guesses has expanded.
parent, Biloxi Co., in one year? Would the change in uncertainty cause the prevailing
34. Uncertainty Surrounding an MNC’s value of Alpine Co. to increase, decrease, or remain
Cash Flows unchanged? Briefly explain.
a. Assume that Bangor Co., a U.S. firm, knows that 37. Exposure of MNC Cash Flows
it will have cash inflows of $900,000 from domestic a. Rochester Co. is a U.S. firm that operates a
operations, cash inflows of 200,000 Swiss francs due language institute in France. This institute attracts
to exports to Swiss operations, and cash outflows of Americans who want to learn the French language.
500,000 Swiss francs at the end of the year. While the Rochester Co. charges tuition to the American
students in dollars. It expects that its dollar revenue exchange rate risk for this project or for the project for
from charging tuition will remain stable over each of American students? Briefly explain.
the next several years. Its total expenses for this proj-
ect are as follows: It rents a facility in Paris, and makes Critical Thinking
a large rent payment each month in euros. It also hires
several French citizens as full-time instructors, and Impact of the International Environment on
pays their salary in euros. It expects that its expenses MNC Cash Flows Conduct an online search to
denominated in euros will remain stable over each of review a recent annual report of the operations of any
the next several years. If the euro appreciates against publicly traded U.S.-based MNC. Write a brief essay
the dollar over time, should this have a favorable in which you describe how the MNC’s cash flows are
effect, an unfavorable effect, or no effect on the value exposed to the international environment. Is the MNC
of Rochester Co.? Briefly explain. you selected most exposed to a particular currency? If
so, how would depreciation of that currency against the
b. Rochester considers a new project in which it dollar affect the value of the MNC? Is the MNC exposed
would also attract people from Spain, and the insti- to economic conditions in a particular foreign country?
tute in France would teach them the French language. If so, describe how a change in the conditions of that
It would charge these students tuition in euros. The country could adversely affect the MNC’s cash flows.
expenses for this project would be about the same as
the expenses of the project described in part (a) for the Discussion in the Boardroom
American students. Assume that euros to be generated
by this project would remain stable over the next sev- This exercise can be found in Appendix E at the back
eral years. Assume that this project is about the same of this textbook.
size as the project for American students. For either
project, the expected annual revenue is just slightly Running Your Own MNC
larger than the expected annual expenses. Is the valu- This exercise can be found in the International Financial
ation of net cash flows subject to a higher degree of Management MindTap.
BLADES, INC. CASE

Decision to Expand Internationally
Blades, Inc., is a U.S.-based company that has been high-quality roller blades and employs a unique pro-
incorporated in the United States for 3 years. Blades duction process, but the prices it charges are among the
is a relatively small company, with total assets of only top 5 percent in the industry.
$200 million. The company produces a single type In light of these circumstances, Ben Holt, the com-
of product, roller blades. Due to the booming roller pany’s chief financial officer (CFO), is contemplating
blades market in the United States at the time of the alternative courses to take for Blades’ future. Blades
company’s establishment, Blades has been quite suc- cannot implement any additional cost-cutting mea-
cessful. For example, in its first year of operation, it sures in the United States without affecting the quality
reported a net income of $3.5 million. Recently, how- of its product. Also, production of alternative products
ever, the demand for Blades’ “Speedos,” the company’s would require major modifications to the existing plant
primary product in the United States, has been slowly setup. Furthermore, and because of these limitations,
tapering off, and Blades has not been performing well. expansion within the United States at this time seems
Last year, it reported a return on assets of only 7 per- pointless.
cent. In response to the company’s annual report for Holt is considering the following: If Blades cannot
its most recent year of operations, Blades’ shareholders penetrate the U.S. market further or reduce costs here,
have been pressuring the company to improve its per- why not import some parts from overseas and/or expand
formance; its stock price has fallen from a high of $20 the company’s sales to foreign countries? Similar strat-
per share 3 years ago to $12 last year. Blades produces egies have proved successful for numerous companies
that expanded into Asia in recent years, allowing them sales before Thai competitors are able to penetrate the
to increase their profit margins. The CFO’s initial focus Thai market.
is on Thailand. Thailand has recently experienced weak As a financial analyst for Blades, Inc., you are
economic conditions, and Blades could purchase com- assigned to analyze international opportunities and
ponents there at a low cost. Holt is aware that many of risk resulting from international business. Your initial
Blades’ competitors have begun importing production assessment should focus on the barriers and opportu-
components from Thailand. nities that international trade may offer. Holt has never
Not only would Blades be able to reduce costs by been involved in international business in any form and
importing rubber and/or plastic from Thailand due to is unfamiliar with any constraints that may negatively
the low costs of these imports, but it might also be able affect his plan to export to and import from a foreign
to augment its weak U.S. sales by exporting its finished country. Holt has presented you with a list of initial
products to Thailand, an economy still in its infancy questions that you should answer.
and just beginning to appreciate leisure products such
1. What are the advantages that Blades could gain
as roller blades. Although several of Blades’ com-
from importing from and/or exporting to a foreign
petitors import components from Thailand, few are
country such as Thailand?
exporting to the country. Long-term decisions would
also eventually have to be made: Perhaps Blades could 2. What are some of the disadvantages that Blades
establish a subsidiary in Thailand and gradually shift could face as a result of foreign trade in the short run?
its focus away from the United States if its U.S. sales In the long run?
do not rebound. Establishing a subsidiary in Thailand
3. Which theories of international business described
would also make sense for Blades due to its superior
in this chapter apply to Blades in the short run? In the
production process. Holt is reasonably sure that Thai
long run?
firms could not duplicate the high-quality production
process employed by Blades. Furthermore, if the com- 4. What long-range plans other than establishment
pany’s initial approach of exporting works well, estab- of a subsidiary in Thailand are an option for Blades
lishing a subsidiary in Thailand would preserve Blades’ and may be more suitable for the company?
SMALL BUSINESS DILEMMA

Developing a Multinational Sporting Goods Corporation
In every chapter of this text, some of the key concepts football could possibly penetrate the U.S. market. He
are illustrated with an application to a small sporting also knew how to produce footballs. His goal was to
goods firm that conducts international business. These create a firm that would produce low-priced footballs
“Small Business Dilemma” features allow students to and sell them on a wholesale basis to various sporting
recognize the challenges and possible decisions that goods stores in the United States. Unfortunately, many
firms (such as this sporting goods firm) may face in a sporting goods stores began to sell low-priced foot-
global environment. For this chapter, the focus is on the balls just before Logan was about to start his business.
development of the sporting goods firm that would con- The firm that began to produce the low-cost footballs
duct international business. already provided many other products to sporting
Last month, Jim Logan completed his undergra- goods stores in the United States, so it had an estab-
duate degree in finance and decided to pursue his lished business relationship with them. Logan did not
dream of managing his own sporting goods business. believe that he could compete with this firm in the
Logan had worked in a sporting goods shop while U.S. market.
attending college and had noticed that many cus- Rather than pursue a different business, Logan
tomers wanted to purchase a low-priced football. decided to implement his idea on a global basis.
However, the sporting goods store where he worked, Although football (as it is played in the United States)
like many others, sold only top-of-the-line footballs. has not been a traditional sport in foreign countries, it
From his experience, Logan was aware that top-of-the- has become more popular in some foreign countries
line footballs had a high markup and that a low-cost in recent years. Furthermore, the expansion of cable
networks in foreign countries would allow for much the cost of the materials used to produce the footballs
more exposure to U.S. football games in those countries and the expenses associated with finding distributors in
in the future. To the extent that this would increase the foreign countries who would attempt to sell the footballs
popularity of football (U.S. style) as a leisure activity in to sporting goods stores.
the foreign countries, it would result in a demand for 1. Is Sports Exports Company a multinational
footballs in foreign countries. corporation?
Logan asked many of his foreign friends from his col-
lege days if they recalled seeing footballs sold in their 2. Why are the agency costs lower for Sports Exports
home countries. Most said they rarely noticed foot- Company than for most MNCs?
balls being sold in sporting goods stores but that they 3. Does Sports Exports Company have any compar-
expected the demand for footballs to increase in their ative advantage over potential competitors in foreign
home countries. countries that could produce and sell footballs there?
Consequently, Logan decided to start a business of
4. How would Jim Logan decide which foreign mar-
producing low-priced footballs and exporting them to
kets he would attempt to enter? Should he initially
sporting goods distributors in foreign countries. Those
focus on one or many foreign markets?
distributors would then sell the footballs at the retail
level. Logan planned to expand his product line over 5. Sports Exports Company has no immediate plans
time once he identified other sports products that he to engage in direct foreign investment. However, it
might sell to foreign sporting goods stores. He decided might consider other less costly methods of establish-
to call his business “Sports Exports Company.” To ing its business in foreign markets. What methods
avoid any rent and labor expenses, Logan planned to might the Sports Exports Company use to increase its
produce the footballs in his garage and to perform the presence in foreign markets by working with one or
work himself. Thus, his main business expenses were more foreign companies?
INTERNET/EXCEL EXERCISES
The website address of the Bureau of Economic Analysis DFI in France. Offer a possible reason for the large
is www.bea.gov. difference.
1. Use this website to assess recent trends in direct 2. Based on the recent trends in DFI, are U.S.-based
foreign investment (DFI) abroad by U.S. firms. MNCs pursuing opportunities in Asia? In Eastern
Compare the DFI in the United Kingdom with the Europe? In Latin America?
ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent article online that describes an actual search terms (and include the current year as a search
international finance application or a real-world exam- term to ensure that the online articles are recent).
ple about a specific MNC’s actions that reinforces one or 1. company AND repatriated foreign earnings
more of the concepts covered in this chapter. 2. Inc. AND repatriated foreign earnings
If your class has an online component, your profes-
3. company AND currency effects
sor may ask you to post your summary there and pro-
vide the Web link of the article so that other students 4. Inc. AND currency effects
can access it. If your class is live, your professor may 5. company AND country risk
ask you to summarize your application in class. Your 6. Inc. AND country risk
professor may assign specific students to complete this
7. direct foreign investment
assignment for this chapter or may allow any students
to do the assignment on a volunteer basis. 8. joint venture AND international
For recent online articles and real-world examples 9. licensing AND international
applied to this chapter, consider using the following 10. multinational corporation AND risk

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1

CHAPTER Multinational corporations (MNCs) are defined as firms that engage in

1-1 Managing the MNC

1-1a How Business Disciplines Are Used to Manage the MNC

1-1b Agency Problems

The costs of ensuring that managers maximize shareholder wealth (referred to as

Corporate Control of Agency Problems In some cases, agency problems can

How SOX Improved Corporate Governance of MNCs One limitation of the

1-1c Management Structure of an MNC

Exhibit 1.1 Management Styles of MNCs

1-2 Why MNCs Pursue International Business

1-2a Theory of Comparative Advantage

1-2b Imperfect Markets Theory

1-2c Product Cycle Theory

Exhibit 1.2 International Product Life Cycle

1-3 Methods to Conduct International Business

WEB 1-3a International Trade

1-3d Joint Ventures

1-3e Acquisitions of Existing Operations

1-3f Establishment of New Foreign Subsidiaries

1-3g Summary of Methods

Exhibit 1.3 Cash Flow Diagrams for MNCs

International Trade by the MNC

Cash Inﬂows from Exporting

Cash Outﬂows to Pay for Importing

Licensing, Franchising, Joint Ventures by the MNC

Cash Inﬂows from Services Provided

Cash Outﬂows for Services Received

Investment in Foreign Subsidiaries by the MNC

Cash Inﬂows from Remitted Earnings

Cash Outﬂows to Finance the Operations

1-4 Valuation Model for an MNC

1-4a Domestic Valuation Model

1-4b Multinational Valuation Model

Valuation of an MNC’s Cash Flows over Multiple Periods The process of

1-4c Uncertainty Surrounding an MNC’s Cash Flows

Exhibit 1.4 How an MNC’s Valuation Is Exposed to Uncertainty (Risk)

Uncertain foreign currency cash ﬂows

Uncertainty Surrounding an MNC’s Valuation:

Exposure to Foreign Economies: If [CFj,t , E (CFj,t )] V

Exhibit 1.5 Potential Effects of International Economic Conditions

Exposure to Exchange Rate Risk If the foreign currencies to be received by a

Austin’s $ cash flows resulting

Austin’s $ cash flows resulting

1-4d How Uncertainty Affects the MNC’s Cost of Capital

1-5 Organization of the Text

Exhibit 1.6 Organization of Chapters

QUESTIONS AND APPLICATIONS

BLADES, INC. CASE

SMALL BUSINESS DILEMMA

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

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