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INTERNATIONAL FINANCE

Lecture 3

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Overview of Lecture 2

• Goal of the multinational corporation (MNC)

• Key theories (Comparative, Imperfect Markets Theory,

Product Cycle Theory)

• Agency Problem and Agency Costs

• Centralized vs. Decentralized system

• The International Product Life Cycle

Local Demand→ Foreign Demand→ F.

Subsidiaries→ Differentiates or F. Business

Declines

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International Financial Management

An Overview

Lecture 3

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Lecture Objectives

To explain the common methods used to

conduct international business.

Provide a model for the valuation of MNC.

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How Firms Engage in International Business • International trade

• Licensing

• Franchising

• Joint ventures

• Acquisitions of existing operations

• Establishing new foreign subsidiaries

 

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International Trade

• Conservative / Traditional Approach

• Involves exporting or importing

• Used by firms to penetrate into markets

• If the firm faces any decline in importing or

exporting, it can reduce or discontinue.

• Internet facilitates the warehouses.

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International Trade

• Use WebPages

• Advertise with prices

• Update the WebPages for changes

• Importers monitor the changes

• Accept orders online

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Licensing

• Allows a firm to provide its technology in

exchange for fees or some other benefits.

• Quality assurance is difficult.

• They may use manufacturers in foreign

countries to produce some of their products.

• This expedites the delivery process.

• Offers lower cost.

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Licensing

• Copyrights, patents, trade marks or

trade names

• Firms with Brand names

• Using internet and finding manufacturers

• Use manufacturers in foreign countries

to produce some of their products.

• Subject to specifications

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Franchising

• Obligates a firm to provide

A specialized sales or service

Support assistance,

Possibly an initial investment, in exchange for

periodic fees.

McDonald’s, Pizza Hut, Subway Sandwiches, that are

owned and managed by local residents in many

foreign countries

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Franchising

• Like licensing, franchising allows firms

to penetrate into markets without major

investments in foreign countries.

• Relaxation of barriers has promoted

numerous franchising arrangements.

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Joint Venture

• A joint venture is a venture that is jointly

owned and operated by two or more firms.

• For example, General Mills, Inc., joined in a

venture with Nestlé, so that the cereals

produced by General Mills could be sold

through the overseas sales by Nestlé.

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Joint Venture

• Xerox Corp and Fuji Co. (Japan) entered into a joint

venture .

• Allowed Xerox to penetrate in to the Japanese Market

• Fuji entered into photocopying business.

• General Motors has ongoing joint ventures in many

countries for automobile manufacturers.

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Acquisitions

• Acquisitions of existing operations in foreign countries

allow firms to quickly gain control over foreign

operations as well as a share of the foreign market.

• Procter & gamble purchased a bleach company in

Panama.

• Subject to the risk of large losses, because of the

large investment required

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Acquisitions

• Some firms enter into partial international

acquisitions

• Requires smaller investments

• Exposed to less risk

• In that case, firms don’t get full control over

foreign operations.

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New Foreign Subsidiaries

• Firms can also penetrate foreign markets by

establishing new foreign subsidiaries.

• Many MNCs use a combination of methods to

increase international business.

• This method is preferred over acquisitions since

you get tailored operations as the firm requires.

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Direct Foreign Investment (DFI)

In general, any method of conducting business

that requires a direct investment in foreign

operations is referred to as a direct foreign

investment (DFI).

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International Opportunities

• Investment opportunities

The marginal returns on MNC projects are

more than domestic firms since MNCs have

expanded opportunity sets of possible

projects from which to select.

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International Opportunities

• Financing opportunities

MNCs can obtain capital funding at a lower

cost due to their larger opportunity set of

funding sources around the world.

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Investment Opportunities

• The figure on next slide shows hypothetical

investment opportunities for domestic and

international firms.

• Each horizontal step represents the marginal return

of the firm.

• Left to right projects are prioritized on the basis of

marginal returns.

• Firms will opt for those options that produce higher

marginal returns.

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Marginal Return on

Projects

Purely Domestic Firm

MNC

Asset Levelof Firm

InvestmentOpportunities

International OpportunitiesCost-Benefit Evaluation for

Purely Domestic Firms versus MNCs

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

X Y

Marginal Cost of Capital

Purely Domestic Firm MNC

FinancingOpportunities

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Financing Opportunities

• The figure shows cost of capital curve for domestic and international firms.

• The cost of capital increases with asset size.

• Growth in asset size requires the increased debt that leads to

¤ Increased interest payments¤ Greater probability of being unable to meet debt

obligations¤ Cost of capital rises to a firm with its volume of

assets

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Financing Opportunities

• If Marginal costs exceeds the marginal returns

¤ The firms should not pursue with such project¤ For domestic firms accept projects up to “point

X”¤ For MNC’s accept projects up to “point Y”

• After that point the marginal cost of additional projects exceeds the expected benefits.

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International Opportunities

• Opportunities in Europe

¤ The Single European Act of 1987 (uniform regulations

removed taxes)

¤ The removal of the Berlin Wall in 1989 (East & West

Germany)

¤ The inception of the euro in 1999 (single currency in

all over Europe)

¤ The expansion of the European Union (more countries

to become members)

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International Opportunities

• Opportunities in Europe

¤ Restrictions on trade will be reduced

¤ Wages are low in some of the member countries

¤ MNC have started their manufacturing plants

¤ Governments in EU are promoting MNCs and are

offering reduced taxes with incentives

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Overview

• Common methods to conduct international business• International trade, Licensing, Franchising, Joint ventures, Acquisitions of

existing operations, Establishing new foreign subsidiaries

Investment opportunities Financing opportunities Marginal Returns and Marginal Costs

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Source: Adopted from South-Western/Thomson Learning. 2006