f55 Ch01 Intro & Overview

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Introduction andOverview:

Chapters 1 & 1A

Chapter Objectives& Lecture Notes

FINA 5500


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Chapter Objectives: FINA 5500Chapter 1 / Multinational Financial Management: An Overview

1. To be able to identify the goals of an multinational corporation (MNC)

2. To be able to compare and contrast the investment and financing decision of an MNCand a domestic corporation .

3. To be able to use the cash flow valuation model to estimate the value of a domestic andmultinational firm

4. To be able to explain in your own words the concept of foreign exchange (FX) risk

5. To be able to explain the extent to which MNCs, exporters, importers and domesticcorporations are exposed to FX risk

6. To be able to explain in your own words the imperfect market theory of internationalbusiness

7. To be able to explain in your own words the flat world theory of international business

8. To be able to explain in your own words the concept of comparative advantage

9. To be able to calculate the opportunity cost of producing one product in terms of anotherproduct

10. Using opportunity costs data should be able to evaluate which country has the

comparative advantage in producing a product

11. To be able to explain in your own words the product cycle theory of internationalbusiness

12. To be able to compare and contrast the comparative advantage, imperfect market, andproduct cycle theories of international business


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OVERVIEW : CHAPTER 1

Goals of MNCTheories of International Business

WHAT IS THE STUDY OFINTERNATIONAL FINANCE ?

decisions in a global market.Cash flows associated with thesedecisionsRisks associated with these cash flowsThe international financial markets


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Mutinational Corporate Balance SheetMutinational Corporate Balance Sheet Global Financial MarketGlobal Financial MarketGlobal Product MarketGlobal Product MarketCash OutlaCash Outla

Corporate ManagerCorporate Manager(Agent)(Agent)

OVERVIEW : INTERNATIONAL FINANCIAL MANAGEMENT

ssetsssets a t esa t esShort TermShort Term Short TermShort Term

Curent AssetsCurent Assets Current LiabilitiesCurrent LiabilitiesLong TermLong Term Long TermLong Term

LandLand DebtDebtPlantPlantEquipmentEquipment Equity (Owner)Equity (Owner)

Corporate / Govt SecuritiesCorporate / Govt Securities

BondsBonds

Stock Stock

Cash RevenueCash RevenueCash ExpenseCash Expense

Net Cash FlowsNet Cash Flows

Shareholders Wealth MaximizationShareholders Wealth MaximizationCapital BudgetingCapital BudgetingMaximize:Maximize:

Cost of CapitalCost of CapitalMinimize:Minimize:

(Agency Problems)(Agency Problems)NPV / IRRNPV / IRR

ost o e tost o e tCost of EquityCost of Equity

* Foreign Currency Market & Exchange Rates* Foreign Currency Market & Exchange Rates* Foreign Exchange (FX) Risk * Foreign Exchange (FX) Risk * International Trade, BOP, Flow of Funds & Exchange Rates* International Trade, BOP, Flow of Funds & Exchange Rates* Governments Role* Governments Role* International Parity Conditions* International Parity Conditions* Measuring and Managing FX Risk * Measuring and Managing FX Risk * Raising & Investing Capital in a Global Market* Raising & Investing Capital in a Global Market

GOAL OF A MULTINATIONALCOMPANY

Maximize Shareholders WealthDiscounted Cash Flow Valuation Model:

( )( )

Value =E CF $,

=

t t

t

n

k11 +=

, received at the end of period t n = the number of periods into the future in

which cash flows are receivedk = the required rate of return by investors


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SOURCE OF MNCS CASHFLOWS

De ends On Methods Of DoinInternational Business:

International TradeLicensingFranchisingJoint Venture

Acquisition of Existing OperationEstablishing New Foreign Subsidiaries

RISK

The risk that cash flows from operationswill fluctuate if exchange rates fluctuate.Multinational corporations, importers,exporters, and domestic firms, are all

.Country/Political Risk


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4

VALUATION MODEL FORAN MNC (1)

Valuing International Cash Flows

( ) ( )] m

) ( )]( )

Value =, ,

=

j j

t t

n

k

+

=11 1

where E (CF j,t ) = expected cash flows denominatedin currency j to be received by the

. . paren a e en o per oE (ER j,t ) = expected exchange rate at which

currency j can be converted todollars at the end of period t k = the weighted average cost of capital of

the U.S. parent company

VALUATION MODELFOR AN MNC (2)

Impact of New International Opportunitieson an MNCs Value

More Exposure to Exchange Rate Risk

New International Opportunities

More Exposure to Political Risk

More Exposure to Foreign Economies

( ) ( )]

( )Value =

E CF E ER, ,

=

j t j t j

m

t t

n

k

+

=11 1


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INTERNATIONALFINANCIAL MARKETS

Involves the study of:Exchange rate regimesFinancial institutionsFinancial instrumentsInternational finance modelsCurrent international finance issues.

markets, instruments, risks and rewardsaffect investment and financing decisions

THEORIES OFINTERNATIONAL BUSINESS

Comparative AdvantageProduct CycleA Flat World


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IMPERFECT MARKETTHEORY

production:

LandLaborCapital

Entrepreneurship

COMPARATIVEADVANTAGE THEORY

Classical theory of international trade


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PRODUCT CYCLE THEORY

one firm in one countryThe firm exploits that productdomesticallyThe firm ex ands overseas as

Raw material seekerNew market seekerCost minimizer

A FLAT WORLD THEORYThree Phases of Globalization (from the book, The World is Flat by Thomas

Friedman)Globalization 1.0 1492 Discover of America 1800 :

Key driver: muscle power (e.g., military, horsepower, wind, steam power)Key players : countries and governments

Globalization 2.0 (1800, Industrial Revolution 2000): Key driver : efficiencies associated with Industrial revolution, mostly due tobreakthrough in:

transportation: steam engines, rail road,telecommunication: telegraphs, telephone, computer, satellites, fiber optics, emails, earlywww

Key players : multinationals tapping into new markets, sources of labor and rawmaterial.

Globalization 3.0 (Post-2000): Key driver: triple convergence

ComputingHigh Speed Data TransferWork Flow Software

Key players : individuals and companies skilled at exploiting the three medium (see theattachment: Dells Production System).


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1

Formula: MNC Valuation Model

( ) ( )]( )

Value =E CF E ER, ,

=

j t j t j

m

t t

n

k

+

=11 1

where E (CF j,t ) = expected cash flows denominatedin currency j to be received by theU.S. parent at the end of period t

E (ER j,t ) = expected exchange rate at whichcurrency j can be converted todollars at the end of period t

k = the weighted average cost of capital ofthe U.S. parent company

Formula: Opportunity Costs

The opportunity cost of product X (interms of product Y)= How many units of product Y does it taketo make one unit of product X= number of units of product Y per one unit

of product X= cost of Y / cost of X


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Valuation Example 1: DomeFirm

Value = 10,000 / (1.10) 1 + 10,000 / (1.10) 2

= 9091 + 8265= $ 17, 356

K = 10%

$ 10$ 10,000Cash flow

YeYear 1


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Valuation Example 2: MN

$20,000$2.0020,000British Pound

CF (Yr 1): 100,000+ 100,000 * 0.10 + 20,000 * 2.00 = $150,00

CF (Yr 2): 100,000+ 100,000 * 0.08 + 20,000 * 2.50 = $158,00Value = 150,000 / (1.10) 1 + 158,000 / (1.10) 2 = $266,943

K = 10%

$100,000$0.10100,000Mexican Peso

100,000100,000Dollar

ECash flowExchange RateCash flow

YeaYear 1


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Yen and Euro: 2004 - 2009

Yen Euro


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s : n- ass xe c

,and losers during both the 2005 and thebased on the ra hs of Yen and Euro rices:

Exxon is a net buyer of raw material and services from Europe

mer can o ors as no expor mpor w t ot er countr es


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What is Opportunity Cost ?

In an economy with limited resources we always have to give up (or trade-off)something to have more of something else. Economists use the opportunity cost

concept to analyze trade-offs between goods. Opportunity cost measures the number

of units of a certain good one must give up in order to obtain an extra unit of anothergood. So, with our limited budgets, if we have to sacrifice two slices of pizzas toafford an extra pitcher of beer, then the opportunity cost of a pitcher of beer is twopizza slices!

Let us say that you want to measure the price (or cost) of one good (for example,candy bars) in terms of another good (for example, postage stamps). Suppose one

dollar can buy two candy bars or four postage stamps . Now let us suppose that youeliminate money!

Then we can say that one candy bar is equal to 2 (= 4 / 2) postage stamps. That is, theopportunity cost of a candy bar is two postage stamps, or one candy bar costs twopostage stamps. We can think of candy bar as the good and postage stamps as money .If we buy candy bars, we will have to pay two postage stamps for each, and if we sellone we will receive two postage stamps in return.

We can also say that one postage stamp is equal to 0.5 (= 2 / 4) candy bars. That is, theopportunity cost of a postage stamp is a candy bar, or one postage stamp costs acandy bar. In this case, we are assuming that postage stamps are the goods and candybars are money . So, if we buy postage stamps we will have to pay a candy bar foreach, and if we sell one we will also receive a candy bar for each.

You may have noticed that when we calculate the opportunity cost of an item, we use a ratio . In that ratio, the denominator is always the number associated with the itemwhose opportunity cost we are calculating.

Therefore, the opportunity cost of good X in terms of good Y= Number of units of Y / Number of units of X

Or

1 unit of good X = (Number of units of Y / Number of units of X) units of good Y


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Here are several examples of how to calculate the opportunity costs of two products based on ththem:

Product # 1 Product # 2 Opportunity costs

$ 1 buys 2 candies $1 buys 4 stamps 1 candy = 4/2 = 2 stamps 1 sta$1,000,000 buys 4 cars $1,000,000 buys 10 boats 1 car = 10/4 = 2.5 boats 1 boa

Output/hour = 25calculators

Output/hour = 5computers

1 calculator = 5/25 = 0.2computers

1c

1 worker can produce8000 lbs of wheat

1 worker can produce2000 lbs of cotton

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

14


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Comparative Advantage: Example

1 C = 3 / 9 = 0.31 F = 9 / 3 = 3.00 CJapan

US will be a net exporter of F to Japan, and a net importer of C from JJapan will be a net exporter of C to US, and a net importer of F from U

Both countries will trade with each other only when:

The price of one unit of F, is between 0.50 C and 3.00 C, orThe price of one unit of C, is between 2.00 F and 0.33 F

1 C = 2 / 1 = 2.001 F = 1 / 2 = 0.50 CUSCost of C (in termCost of F (in terms of C)

Opportunity Cost

93Japan

12US

ClothinFood ( F )

Total Output Per Worker


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Comparative Advantage: Example 1 (c

U U / A1 F = 0.40 C

U U / A1 C = 0.25 F

U U / A1 F = 4.00 C

U U / A1 F = 2.00 C

U U / A1 C = 3.00 FJaUS

0.33 F3.00 CJapan

U U / A1 C = 1.50 F

2.00 F0.50 CUS

Cost of C (in termCost of F (in terms of C)

Opportunity Cost


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Comparative Advantage: In-class Exe

U U / A1 F = 0.01 CU U / A1 F = 0.04 C

U U / A1 C = 35 F

GermUS

Germany

U U / A1 C = 52 F

USCost of C (in termCost of F (in terms of C)

Opportunity Cost

201000Germany

10400US

ClothingFood ( F )Total Output Per Worker


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Comparative Advantage Problem Set #1

Please answer the four questions based on the data provided in the following table.

Computers Calculators

Output / worker in US 10 2000

Output / worker in UK 12 3000

1. Estimate how many computers it takes to produce one CALCULATOR in:

2. Estimate how many calculators it takes to produce one COMPUTER in:

3. Which country (US or UK) should be a net exporter of COMPUTERS? US

4. Indicate if the following terms of trade are acceptable (A) or unacceptable (U) to US and UK.

US (indicate A or U) UK (indicate A or U)

1 computer = 180 calculators

1 calculator = 0.0038 computers

1 computer = 260 calculators

1 calculator = 0.0055 computers


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Comparative Advantage Problem Set #2

Please answer the four questions based on the data provided in the following table.

Coffee Tea

Output / worker in Brazil 9000 lbs 300 lbs

Output / worker in China 5000 lbs 200 lbs

1. Estimate how many pounds of coffee it takes to produce one pound of TEA in Brazil :

2. Estimate how many pounds of tea it takes to produce one pound of COFEE in China :

3. Which country (Brazil or China) should be a net exporter of Tea? CHINA

4. Indicate if the following terms of trade are acceptable (A) or unacceptable (U) to Brazil and China

Brazil China

1 pound of Tea = 32 pounds of Coffee U A

1 pound of Coffee = 0.035 pounds of Tea A A

1 pound of Coffee = 0.065 pounds of Tea A U

1 pound of Tea = 20 pounds of Coffee A U

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