Chapter 1 – Multinational Financial Management Overview

Group D:
Aya Amir Ahmed Tawfik
Heba Mostafa Youssef Elzahed
Mohamed Helmy Aly Ahmed
MNC Definition

Multinational corporations MNCs are defined as firms that engage in some form of international business. MNCs
Managers conduct international financial management. Firms like IBM, Nike have more than half of their assets in
foreign countries. Other businesses like Fortune Brands and Colgate-Palmolive commonly generate more than half
of their sales in foreign countries.

MNC Goals

The main goal of an MNC is to maximize shareholders’ wealth though increasing the stock price and therefore serve
shareholders.

How business disciplines are used to manage the MNC

An agency problem may occur if MNCs managers make decisions that conflict with the firm’s goals to maximize
shareholders’ wealth. The costs of ensuring that managers maximize shareholders’ wealth (referred to as agency
costs) are normally larger for MNCs than for purely domestic firms because MNCs tend to experience greater agency
problems than do domestic firms because managers of foreign subsidiaries might be tempted to focus on making
decisions to serve their subsidiaries rather than serving their overall MNCs. Proper incentives and communication
from the parent (parent control of agency problems) may help ensure that subsidiary managers focus on serving
the overall MNC.

Management Structure of an MNC

Management styles of MNCs

 Centralized Multinational Financial Management

Can reduce agency costs because it allows managers of the parent to control foreign subsidiaries and
therefore reduce the power of subsidiary mangers. However, the parent’s managers may make poor
decisions for the subsidiary if they are not informed as subsidiary managers about the financial
characteristics of the subsidiary.
 Decentralized Multinational Financial Management
This style is more likely to result in higher agency costs because subsidiary managers may make decisions
that do not focus on maximizing the value of the entire MNC. Yet this style gives ore control to managers
who are closer to the subsidiary’s operations and environment.

Given the tradeoff between centralized and decentralized management styles, some MNCs attempt to achieve the
advantages of both styles. That is, they allow subsidiary managers to make the key decisions to ensure that they are
in the best interests of the entire MNC.

Why firms Pursue International Business

International business is justified by three key theories.

 The theory of comparative advantage suggests that each country should use its comparative advantage to
specialize its production and rely on other countries to meet other needs because when specializes in some
products, it may not produce other products so trade between countries is essential. Comparative
advantage allows firms to penetrate foreign markets.
 The imperfect markets theory suggests that because of imperfect markets, factors of production are
immobile. There are costs and restrictions related to the transfer of labor and other resources used for
 production as well as transferring funds among countries, which encourages countries to specialize based
on the resources they have.
 The product cycle theory suggests that after firms are established in their home countries as a result of
some perceived advantage over existing competitors such as the need by the market for at least one more
supplier of the product, foreign demand for the firm’s product will initially be accommodated by exporting.
As time passes, the firm may feel the only way to retain its advantage over competition in foreign countries
is to produce the product in foreign markets, thereby reducing its transportation costs.

Methods used by firms for conducting international business

There are several methods used by firms for conducting international business. The most common methods
are international trade, licensing, franchising, joint ventures, acquisitions of existing operations and
establishing new foreign subsidiaries.
Initially, international trade is a method for penetrating foreign markets without directly investing in those
markets and without putting the firm’s capital at risk. In other words, international trade is used in order to
penetrate foreign markets through exporting or to obtain supplies at a low cost through importing. The
reason why international trade is considered to be the least risky method for conducting international
business is the fact that the firm does not place its capital at risk. Thus if exporting or importing is not
rewarding for the firm, then the firm can simply quit exporting or importing without major losses. MNCs
such as Boeing, IBM and general electric generate more than $4 billion in annual sales from exporting. It is
vital to emphasize that nowadays the internet facilitates international trade by allowing firms to
communicate what they sell with potential buyers and take orders online.
Secondly, licensing is a method for penetrating foreign markets by using the firm’s technology (patents,
copyrights, trademarks or trade names) in foreign markets in exchange for fees or other specified benefits.
For instance, Starbucks makes licensing agreements with SSP which is an operator of food and beverages
in Europe and allows it to sell Starbucks products in train stations and airports throughout Europe. Licensing
does not require the firm to make a major investment in the foreign country and it allows firms to penetrate
international markets without the costs of transportation that are accompanied with exporting. However, a
major drawback of licensing is that it is sometimes hard for the firm providing the technology to ensure
quality control in the foreign production process.
Thirdly, franchising is a method for penetrating foreign markets without a major investment in foreign
countries; it requires the firm to provide specialized sales or service strategy, support assistance and an
initial investment in the franchise in exchange for periodic fees. For instance, Pizza Hut, McDonalds and
Dairy Queen have franchises that are owned and managed by local residents in foreign countries.
As for joint ventures, it’s a method for penetrating foreign markets by engaging in a joint venture with firms
located in those markets. A joint venture is a venture owned and operated by two or more firms and it allows
those firms to apply and merge their comparative advantages in one project.

Another method for penetrating international markets, is the acquisition of existing operations by acquiring
firms in foreign markets, this method allows firms to be fully responsible of their foreign businesses and
gives them the ability to quickly obtain a large portion of foreign market share. However, acquiring an
existing corporation is somehow risky because of the large initial investment needed, moreover, if the
corporation performs badly, the firm might face difficulties in selling the corporation at a reasonable price.
That’s why there are firms that engage in only partial international acquisitions because they require smaller
investment amounts and are less risky.
Last but not least, firms can establish new operations in foreign countries in order to produce and
sell their products, which require large investment amounts. Establishing new subsidiaries can be
less costly than acquiring existing firms. However, the firm won’t harvest any returns unless the
subsidiary is built and a customer base is established..

VALUATION MODEL FOR AN MNC

Domestic Model

V: Firm’s Present Value in n periods

ECF: Expected Cash Flow in local currency for each period
K: the Cost of Capital
Multinational Model

V: Firm’s Present Value in n periods

ECF: Expected Cash Flow in subsidiary currency for each period
ES: Expected Exchange Rate from each currency to the Local Currency
K: the Cost of Capital

Uncertainty Surrounding an MNC’s Cash Flows:

- Exposure to International Economic Conditions
- Exposure to International Political Risk
- Exposure to Exchange Rate Risk

How Uncertainty Affects the MNC’s Cost of Capital

The higher level of uncertainty increases the return on investment required by investors