GOAL OF MULTINATIONAL COMPANIES (MNCs)

Multinational Financial Management: an overview

Goal of multinational companies (MNCs):

Wealth maximization of share holders
There are two ways to maximize the wealth:
Capital Gain
Dividend Increase
MNCs Definition:
When the domestic company started its business in different countries is called
MNCs.
Parent Company: Domestic branch is called main or parent company.
Subsidires Company: In other countries branches is called Subsidires
Company.
Conflicts with Goal:
Agencies problems
Management and share Holders problems
How to remove conflicts:
Stock offer
Centralized decision
Threat of job
Monetary
Constraints with MNCs Goal:
Environmental issues
Regulatory constraints
Ethical

International Business Theories:


Comparative Advantage: Which area the company is stronger than other
company and its competitor is weak in that area
Theory of Imperfect Market: Get the benefit of factor of production because the
factor are not equal in the world the business man can get the befit of that inequality.
Product Life cycle Theory: first of all fulfill domestic demand and after fulfill
MNCs demand.
Goals of the MNC
Maximize shareholder wealth
Problems encountered in meeting goals:
1) Agency problems larger for MNCs than purely domestic firms because:
a) monitoring more difficult because of geographic distance
b) different cultures
c) MNC size
d) subsidiary managers may maximize the value of their subsidiary but not of the
MNC as a whole
2) Centralized vs. decentralized management
a) centralized reduces agency costs because it gives parent more
control; downside is that local managers may be better
informed
b) decentralized management increases agency costs but may
result in better decisions
c) Internet may facilitate monitoring of foreign subsidiaries
3) Corporate control used to reduce agency problems
a) executive compensation with stock
b) threat of hostile takeover
c) monitoring by large shareholders
Constraints encountered in meeting goals
1) Environmental - other countries may be tougher (e.g., pollution
controls)
2) Regulatory - e.g., currency convertibility, remittance of profits, etc.
3) Ethical - e.g., bribes may be more acceptable in other countries

Factors which influence the exchange rate
Exchange rates are determined by supply and demand. For example, if there was greater
demand for American goods then there would tend to be an appreciation (increase in value)
of the dollar. If markets were worried about the future of the US economy, they would tend
to sell dollars, leading to a fall in the value of the dollar.
Note:
Appreciation = increase in value of exchange rate
Depreciation / devaluation = decrease in value of exchange rate.

Main Factors that Influence Exchange Rates
1. Inflation
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more
competitive and there will be an increase in demand for Pound Sterling to buy UK goods.
Also foreign goods will be less competitive and so UK citizens will buy less imports.
Therefore countries with lower inflation rates tend to see an appreciation in the value of
their currency.
2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit
money in the UK. You will get a better rate of return from saving in UK banks, Therefore
demand for Sterling will rise. This is known as hot money flows and is an important short
run factor in determining the value of a currency. Higher interest rates cause
anappreciation.

3. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be
able to make a profit. This increase in demand will cause the value to rise. Therefore
movements in the exchange rate do not always reflect economic fundamentals, but are
often driven by the sentiments of the financial markets. For example, if markets see news
which makes an interest rate increase more likely, the value of the pound will probably rise
in anticipation.
4. Change in Competitiveness
If British goods become more attractive and competitive this will also cause the value of the
Exchange Rate to rise. This is important for determining the long run value of the Pound.
This is similar factor to low inflation.
5. Relative strength of other currencies.
In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets
were worried about all the other major economies US and EU. Therefore, despite low
interest rates and low growth in Japan, the Yen kept appreciating.
6. Balance of Payments
A deficit on the current account means that the value of imports (of goods and services) is
greater than the value of exports. If this is financed by a surplus on the financial / capital
account then this is OK. But a country who struggles to attract enough capital inflows to
finance a current account deficit, will see a depreciation in the currency. (For example
current account deficit in US of 7% of GDP was one reason for depreciation of dollar in
2006-07)
7. Government Debt.
Under some circumstances, the value of government debt can influence the exchange rate.
If markets fear a government may default on its debt, then investors will sell their bonds
causing a fall in the value of the exchange rate. For example, Iceland debt problems in
2008, caused a rapid fall in the value of the Icelandic currency.
For example, if markets feared the US would default on its debt, foreign investors would sell
their holdings of US bonds. This would cause a fall in the value of the dollar.

8. Government Intervention
Some governments attempt to influence the value of their currency. For example, China has
sought to keep its currency undervalued to make Chinese exports more competitive. They
can do this by buying US dollar assets which increases the value of the US dollar to
Chinese Yuan.
9. Economic growth / recession
A recession may cause a depreciation in the exchange rate because during a recession
interest rates usually fall. However, there is no hard and fast rule. It depends on several
factors.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative,
and are expressed as a comparison of thecurrencies of two countries. The
following are some of the principal determinants of the exchange rate between
two countries. Note that these factors are in no particular order; like many
aspects ofeconomics, the relative importance of these factors is subject to much
debate.

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a
rising currency value, as its purchasing power increases relative to other
currencies. During the last half of the twentieth century, the countries with low
inflation included Japan, Germany and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation typically
see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates. (To learn
more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign
capital and cause the exchange rate to rise. The impact of higher interest rates
is mitigated, however, if inflation in the country is much higher than in others,
or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates
tend to decrease exchange rates. (For further reading, see What Is Fiscal
Policy?)

3. Current-Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest
and dividends. Adeficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing capital from
foreign sources to make up the deficit. In other words, the country requires
more foreign currency than it receives through sales of exports, and it supplies
more of its own currency than foreigners demand for its products. The excess
demand for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests. (For more,
see Understanding The Current Account In The Balance Of Payments.)

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to
foreign investors. The reason? A large debt encourages inflation, and if inflation
is high, the debt will be serviced and ultimately paid off with cheaper real
dollars in the future.

In the worst case scenario, a government may print money to pay part of a
large debt, but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through domestic
means (selling domestic bonds, increasing the money supply), then it must
increase the supply of securities for sale to foreigners, thereby lowering their
prices. Finally, a large debt may prove worrisome to foreigners if they believe
the country risks defaulting on its obligations. Foreigners will be less willing to
own securities denominated in that currency if the risk of default is great. For
this reason, the country's debt rating (as determined by Moody's or Standard &
Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's
exports rises by a greater rate than that of its imports, its terms of trade have
favorably improved. Increasing terms of trade shows greater demand for the
country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the
currency's value). If the price of exports rises by a smaller rate than that of its
imports, the currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can cause
a loss of confidence in a currency and a movement of capital to the currencies
of more stable countries.