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INTERNATIONAL FINANCE

Lecture 2

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Lecture 2

International Finance

An Overview

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Chapter Objectives

To identify the main goal of the multinational corporation (MNC) and potential conflicts with that goal

To describe the key theories that justify international business.

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Multinational Financial Management

Multinational corporations are defined as firms that engage in some form of international business. Their managers conduct international financial management.

• International investment and financial decisions

• Maximise the value of firm

• Export products or import supplies

• After maturing in domestic market, the company can distribute in many countries e.g. Coca Cola (deals in different countries with various currencies)

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Subsidiary Managers

• A subsidiary company is one that is a 'sister' or a

'child' company of another usually larger

company.

• So let's say there is company X. Company Y is

another company owned by company X. Therefore

company Y is a subsidiary of company X.

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Goal of the MNC

• The commonly accepted goal of an MNC is to

maximize shareholder wealth.

• We will focus on MNCs that wholly own their

foreign subsidiaries.

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Goal of the MNC

• Financial managers throughout the MNChave a single goal of maximizing the value of the entire MNC.

¤Managers are suppose to make the decisions that can maximise the stock price and therefore serve the stockholders.

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Conflicts with the MNC Goal

• When a company’s shareholders differ from its

managers, a conflict of goals can exist—the

agency problem.

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Agency Problem

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Agency Problem

• A decision to establish a subsidiary in one

location versus another may be based on the

location’s appeal to a particular manager

rather than on its potential benefit to

shareholders.

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Agency Problem

• A decision to expand a subsidiary may be

motivated by a manager’s desire to receive

more compensation rather than to enhance

the value of the MNC.

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Agency Problems

• Agency costs are normally larger for MNCs

than for purely domestic firms, due to:

¤ the difficulty in monitoring distant

managers,

¤ the different cultures of foreign managers,

¤ the sheer size of the larger MNCs, and

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Conflicts with the MNC Goal

• Subsidiary managers may be tempted to make decisions that maximize the values of their respective subsidiaries.

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Parent Control of Agency Problem

The parent corporation of an MNC may be able to prevent agency problems with proper governance.

Clearly communicate the goals of the MNC

Monitoring by parent

Implement compensation plans that reward the subsidiary managers

To provide managers with the MNC’s stock (or options to buy the stock at a fixed price) as part of their compensation

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Corporate Control of Agency Problems

In case of acquisitions due to poor performance

of MNC the new management will replace the

managers.

Institutional investors can complain to board of

directors and replace the poor management.

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Impact of Management Control

• The magnitude of agency costs can vary with the management style of the MNC.

• Centralized

• Decentralized

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Centralized Multinational Financial Management

for an MNC with two subsidiaries, A and B

FinancialManagersof Parent

Capital Expendituresat A

Inventory andAccounts

ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B

Inventory andAccounts

ReceivableManagement at B

CashManagement

at B

Financing at B

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Decentralized Multinational Financial Management

for an MNC with two subsidiaries, A and B

FinancialManagers

of A

Capital Expendituresat A

Inventory andAccounts

ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B

Inventory andAccounts

ReceivableManagement at B

CashManagement

at B

Financing at B

FinancialManagers

of B

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Impact of Management Control

• Some MNCs attempt to strike a balance – they

allow subsidiary managers to make the key

decisions for their respective operations, but the

parent’s management monitors the decisions.

• Today, electronic networks make it easier for the

parent to monitor the actions and performance of

its foreign subsidiaries.

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MNCs Improvement for Internal Control Process

• 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

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MNCs Improvement for Internal Control Process

• Speeding the process by which all departments

and all subsidiaries have access to the data that

they need

• Making executives more accountable for financial

statements by personally verifying their accuracy

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Impact of Corporate Control

• Various forms of corporate control can reduce agency costs:

¤ stock options¤ hostile takeover threat¤ investor monitoring

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Constraints Interfering with the MNC’s Goal

• MNC managers are confronted with

various constraints:

¤ Environmental Constraints

¤ Regulatory Constraints

¤ Ethical Constraints

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Constraints Interfering with the MNC’s Goal

A recent study found that investors

assigned a higher value to firms that

exhibit high corporate governance

standards and are likely to obey ethical

constraints.

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Why are firms motivated to expand their business internationally?

Theories of International Business

1. Theory of Comparative Advantage

2. Imperfect Markets Theory

3. Product Cycle Theory

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1. Theory of Comparative advantage

Allows firms to penetrate foreign markets.

¤ Specialization by countries¤ More efficiency¤ Technological e.g. US, Japan¤ Agriculture e.g. Jamaica, Mexico

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2. Imperfect Market Theory

If perfect market so factors of production are free mobile & equality of costs and returns.

Imperfect market provides incentive to seek foreign opportunities, Where factors of production are immobile.

¤ Countries differs in term of resources

¤ Costs and restrictions related to labor

¤ Restriction on transferring funds & other sources

¤ MNC’s Nike and Gap capitalize on foreign resources

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3. Product Cycle Theory

As a firm matures in home market, it may recognize additional opportunities outside its home country.

By Exports Competition will increase in foreign markets Strategies to sustain

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Review

• Goals of MNCs

• Agency Problems

• Centralized vs. Decentralized System

• Theories of International Business

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