International Corporate Finance 11 Edition: by Jeff Madura

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International Corporate Finance

11th Edition
by Jeff Madura

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Part 1
The International Financial Environment

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1Multinational Financial Management
Chapter Objectives

 Identify the management goal and organizational


structure of the Multinational Corporation (MNC).
 Describe the key theories that justify international
business
 Explain the common methods used to conduct
international business
 Provide a model for valuing the MNC

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Managing the MNC

1. Managers are expected to make


decisions that will maximize the stock
price.
2. Focus of this text: MNCs whose parents
fully own foreign subsidiaries (U.S. parent
is sole owner of subsidiary.)
3. Finance decisions are influenced by other
business discipline functions:
 Marketing
 Management
 Accounting and information systems
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Agency Problems

The conflict of goals between managers


and shareholders

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Agency Costs

1. Definition: Cost of ensuring that managers


maximize shareholder wealth
2. Costs are normally higher for MNCs than for
purely domestic firms for several reasons:
 Monitoring managers of distant subsidiaries in foreign
countries is more difficult.
 Foreign subsidiary managers raised in different
cultures may not follow uniform goals.
 Sheer size of larger MNCs can create large agency
problems.
 Some non-U.S. managers tend to downplay the
short-term effects of decisions.
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Control of Agency Problems

1. Parent control of agency problems


Parent should clearly communicate the goals for each
subsidiary to ensure managers focus on maximizing the
value of the subsidiary.
2. Corporate control of agency problems
Entire management of the MNC must be focused on
maximizing shareholder wealth.
3. Sarbanes-Oxley Act (SOX)
Ensures a more transparent process for managers to
report on the productivity and financial condition of their
firm.

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SOX Methods to Improve Reporting

 Establishing a centralized database of


information
 Ensuring that all data are reported consistently
among subsidiaries
 Implementing a system that automatically
checks for unusual discrepancies relative to
norms
 Speeding the process by which all departments
and subsidiaries have access to all the data
they need
 Making executives more accountable for
8 financial statements
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Management Structure of MNC

1. Centralized (See Exhibit 1.1a)


Allows managers of the parent to control
foreign subsidiaries and therefore reduce
the power of subsidiary managers
2. Decentralized (See Exhibit 1.1b)
Gives more control to subsidiary
managers who are closer to the
subsidiary’s operation and environment

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Exhibit 1.1a Management Styles of MNCs

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Exhibit 1.1b Management Styles of MNCs

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Why Firms Pursue International Business

1. Theory of Competitive Advantage:


specialization increases production efficiency.
2. Imperfect Markets Theory: factors of production
are somewhat immobile providing incentive to
seek out foreign opportunities.
3. Product Cycle Theory: as a firm matures, it
recognizes opportunities outside its domestic
market.

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Exhibit 1.2 International Product Life Cycles

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How Firms Engage in International Business

1. International trade
2. Licensing
3. Franchising
4. Joint Ventures
5. Acquisitions of existing operations
6. Establishing new foreign subsidiaries

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International Trade

 Relatively conservative approach that can be


used by firms to
 penetrate markets (by exporting)
 obtain supplies at a low cost (by importing).
 Minimal risk – no capital at risk
 The internet facilitates international trade by
allowing firms to advertise their products and
accept orders on their websites.

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Licensing

 Obligates a firm to provide its technology


(copyrights, patents, trademarks, or trade
names) in exchange for fees or some other
specified benefits.
 Allows firms to use their technology in foreign
markets without a major investment and
without transportation costs that result from
exporting
 Major disadvantage: difficult to ensure quality
control in foreign production process
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Franchising

 Obligates firm to provide a specialized sales


or service strategy, support assistance, and
possibly an initial investment in the franchise
in exchange for periodic fees.
 Allows penetration into foreign markets
without a major investment in foreign
countries.

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Joint Ventures

 A venture that is jointly owned and operated


by two or more firms. A firm may enter the
foreign market by engaging in a joint venture
with firms that reside in those markets.
 Allows two firms to apply their respective
cooperative advantages in a given project.

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Acquisitions of Existing Operations

 Acquisitions of firms in foreign countries


allows firms to have full control over their
foreign businesses and to quickly obtain a
large portion of foreign market share.
 Subject to the risk of large losses because of
larger investment.
 Liquidation may be difficult if the foreign
subsidiary performs poorly.

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Establishing New Foreign Subsidiaries

 Firms can penetrate markets by establishing


new operations in foreign countries.
 Requires a large investment
 Acquiring new as opposed to buying existing
allows operations to be tailored exactly to the
firms needs.
 May require smaller investment than buying
existing firm.

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Summary of Methods

 Any method of increasing international


business that requires a direct investment in
foreign operations is referred to as direct
foreign investment (DFI)
 International trade and licensing usually not
included
 Foreign acquisition and establishment of new
foreign subsidiaries represent the largest
portion of DFI.

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Exhibit 1.3 Cash Flow Diagrams for MNCs

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Exhibit 1.3 Cash Flow Diagrams for MNCs

 The first diagram reflects an MNC that engages in


international trade. International cash flows result
from paying for imports or receiving cash flow from
exports.
 The second diagram reflects an MNC that engages in
some international arrangements. Outflows include
expenses such as expenses incurred from
transferring technology or funding partial investment
in a franchise or joint venture. Inflows are receipts
from fees.
 The third diagram reflects an MNC that engages in
direct foreign investment. Cash flows exist between
23 the
© parent
2012 Cengage Learning.company and
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copied, scanned, subsidiary.
or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Valuation Model for an MNC:
Domestic Model

  E  CF$,t   
n
V   t 
t 1  1  k  
Where
 V represents present value of expected cash flows
 E(CF$,t) represents expected cash flows to be received at the
end of period t,
 n represents the number of periods into the future in which
cash flows are received, and
 k represents the required rate of return by investors.

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Valuation Model for an MNC:
Multinational Model

E  CF$,t    E  CF j ,t   E  S j ,t   
m

j 1
Where
 CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,

 Sj,t represents 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.

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Valuation Model for an MNC
An MNC that uses two or more currencies

E  CF$,t    E  CF j ,t   E  S j ,t   
m

j 1
 Derive an expected dollar cash flow value for each currency
 Combine the cash flows among currencies within a given
period

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Uncertainty Surrounding MNC Cash Flows

1. Exposure to international economic conditions – If


economic conditions in a foreign country weaken,
purchase of products decline and MNC sales in that
country may be lower than expected.
2. Exposure to international political risk – A foreign
government may increase taxes or impose barriers on
the MNC’s subsidiary.
3. Exposure to exchange rate risk – If foreign currencies
related to the MNC subsidiary weaken against the
U.S. dollar, the MNC will receive a lower amount of
dollar cash flows than was expected.

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How Uncertainty Affects the MNC’s cost of Capital

A higher level of uncertainty increases the return


on investment required by investors and the
MNC’s valuation decreases.

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Exhibit 1.4 How an MNC’s Valuation is Exposed to
Uncertainty

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Exhibit 1.5 Organization of Chapters

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Summary

 The main goal of an MNC is to maximize shareholder


wealth. When managers are tempted to serve their
own interests instead of those of shareholders, an
agency problem exists. MNCs tend to experience
greater agency problems than do domestic firms.
Proper incentives and communication from the parent
may help to ensure that subsidiary managers focus on
serving the overall MNC.

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Summary

International business is justified by three key


theories.
1. The theory of comparative advantage suggests that
each country should use its comparative advantage
to specialize in its production and rely on other
countries to meet other needs.
2. The imperfect markets theory suggests that
because of imperfect markets, factors of production
are immobile, which encourages countries to
specialize based on the resources they have.
3. The product cycle theory suggests that after firms
are established in their home countries, they
commonly expand their product specialization in
32 foreign
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Summary

 The most common methods by which firms conduct


international business are international trade,
licensing, franchising, joint ventures, acquisitions of
foreign firms, and formation of foreign subsidiaries.
Methods such as licensing and franchising involve little
capital investment but distribute some of the profits to
other parties. The acquisition of foreign firms and
formation of foreign subsidiaries require substantial
capital investments but offer the potential for large
returns.

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Summary

 The valuation model of an MNC shows that the MNC’s


value is favorably affected when its expected foreign
cash inflows increase, the currencies denominating
those cash inflows increase, or the MNC’s required
rate of return decreases. Conversely, the MNC’s value
is adversely affected when its expected foreign cash
inflows decrease, the values of currencies
denominating those cash flows decrease (assuming
that they have net cash inflows in foreign currencies),
or the MNC’s required rate of return increases.

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