Multinational Finance

Multinational enterprise and

multinational financial management

Alon Raviv
FIN-763, Spring 2008
Boston University, The Metropolitan College

FIn 763: Lecture 2 1

Today’s plan
 Part 1: The rise of the multinational corporation
• THE MNC definition, reason for evaluation and
management.
 Part 2: Internationalization of business and finance
 Part 3. Multinational financial management: theory
and practice
• The MNC’s policies
• Function of financial management
• Theoretical foundation
• The global financial market place
FIn 763: Lecture 2 2
 PART 1: THE RISE OF THE
MULTINATIONAL CORPORATION

 I. The MNC: A Definition

• A company with production and distribution
facilities in more than one country.

• with a parent company located in the home

country
• at least five or six foreign subsidiaries

FIn 763: Lecture 2 3

THE RISE OF THE MULTINATIONAL
CORPORATION
 A. Forces Changing Global Markets
• Massive deregulation
• Collapse of communism
• Privatizations of state-owned industries
• Revolution in information technology
• Wave of M&A
• Emergence of free market policies in Third World
Nations
• The unprecedented number of nations submitting
themselves to the exacting rigors standards of the
global marketplace.

FIn 763: Lecture 2 4

THE RISE OF THE MULTINATIONAL
CORPORATION

The Rise of China as a Global

Competitor
 The most dramatic change in
the international economy over
the last decade.
 The number one destination for
foreign direct investment (FDI)
 Note: FDI is the acquisition
abroad of companies, property,
or physical assets

FIn 763: Lecture 2 5

THE RISE OF THE MULTINATIONAL
CORPORATION

C. The MNC’s Evolution Reasons to

Go Global:
1. More raw materials
2. New markets
3. Minimize costs of
production
4. Access to new technologies

FIn 763: Lecture 2 6

THE RISE OF THE MULTINATIONAL
CORPORATION

RAW MATERIAL SEEKERS

• exploit markets in other countries
• historically first to appear: the British, Dutch and
French East India Companies that grow up under the
protective mantle of the colonial empires.
• modern-day counterparts: the multinational oil and
mining companies.

British Petroleum
Exxon

FIn 763: Lecture 2 7

THE RISE OF THE MULTINATIONAL
CORPORATION

 MARKET SEEKERS
• Produce and sell in foreign markets
• Have heavy foreign direct investors
• Represented today by firms such as:
• IBM
• MacDonald’s
• Nestle
• Levi Strauss
FIn 763: Lecture 2 8
THE RISE OF THE MULTINATIONAL
CORPORATION

 COST MINIMIZERS
• seek lower-cost production abroad
• Their motive: to remain cost competitive
• The investment can be done internally by
establishment of wholly owned foreign affiliates
or externally by outsourcing a service.
• Represented today by firms such as:
• Texas Instruments
• Intel
• Seagate Technology
FIn 763: Lecture 2 9
THE RISE OF THE MULTINATIONAL
CORPORATION

D. What is the MNC?

From a Behavioral View:
it’s a state of mind committed to globally
• producing,

• undertaking investment,

• marketing, and financing.

FIn 763: Lecture 2 10

THE RISE OF THE MULTINATIONAL
CORPORATION

E. THE GLOBAL MANAGER:

1. Understands political and economic

differences;
2. Searches for most cost-effective suppliers;
3. Evaluates changes on value of the firm.

FIn 763: Lecture 2 11

 Part II INTERNATIONALIZATION OF
BUSINESS AND FINANCE

I. Globalization
II. Political and Labor Union Concerns
• Corporation that invest abroad are defined as “job exporters”.
III. Consequences of Global Competition:
• The acceleration of the global economy
• International economic integration reduces the freedom of
government to determine their own economic policy.
• The globalization of trade and finance has created an
unforgiving environment that penalizes economic
mismanagement and allots capital and jobs to the nation
delivering the highest risk adjusted return

FIn 763: Lecture 2 12

 What is NAFTA?

• The North American Free Trade Agreement (NAFTA) is one of the

most powerful and wide-reaching treaties in the world.
• NAFTA is a treaty between Canada, Mexico, and the United States
that was designed to foster greater trade between the three
countries. NAFTA has been in effect since 1 January 1994
• NAFTA eliminate a large number of tariffs on goods shipped
between the three countries. Prime examples of these goods were
cars, car parts, computers, and food.
• As a result of NAFTA, Mexico especially has purchased goods
from the US in much greater numbers than before. This saves
Mexican companies money on imports, and it saves American
companies money on export shipping costs.

FIn 763: Lecture 2 13

 The debate over NFTA:
Clinton versus Perot

• The New York Times, NOV -9, 1993:

• Mr. Perot dismisses the foreign policy implications while
manhandling the economic data. In a nine-month anti-
Nafta crusade that has taken him to 43 states and 91
cities, he has warned that Nafta would cause American
industry and agriculture to flee south with "a giant
sucking sound" toward cheaper Mexican labor, costing
Americans 5.9 million jobs.

FIn 763: Lecture 2 14

The debate over NFTA:
Clinton versus Perot

FIn 763: Lecture 2 15

The Results…

FIn 763: Lecture 2 16

The Consequences of NAFTA

FIn 763: Lecture 2 17

The Consequences of NAFTA
 Schiff and Yanling (2002) have found that trade with
Mexico's NAFTA partners has a large and significant
impact on Mexico's trade-related foreign R&D and
total productivity
See: http://ssrn.com/abstract=323040
 Coughlin and Wall (2000) have found that NAFTA
has increased U.S. merchandise exports to Mexico
and Canada by over 15 percent, and has increased
total U.S. merchandise exports by nearly 8 percent
See: http://ssrn.com/abstract=249008

FIn 763: Lecture 2 18

 1997 Asian financial crisis
• For years the nations of South East Asia were
held as economic icon due to:
• High saving rates
• High investment rates.
• Autocratic political system
• Export oriented business
• Government direct capital allocation
• Controlled financial system

All together were hailed as the ideal recipe for strong

economic growth
FIn 763: Lecture 2 19
 1997 Asian financial crisis
• The crisis started in Thailand with the financial collapse of the Thai
Bath caused by the decision of the Thai government to float the baht,
cutting its peg to the USD, after exhaustive efforts to support it.
• At the time Thailand had acquired a burden of Foreign debt that
made the country effectively bankrupt even before the collapse of its
currency.
• The drastically reduced import earnings that resulted from the forced
devaluation then made a quick or even medium-term recovery
impossible without strenuous international intervention.
• As the crisis spread, most of Southeast and Japan saw slumping
currencies, devalued stock markets and asset prices, and a
precipitous rise in private debt.

FIn 763: Lecture 2 20

 The neighboring countries
• Investors then turned to other Asian economies and
saw similar flaws there
• The dominoes effect:

FIn 763: Lecture 2 21

 Table 1: East Asian GDP
Average annual percentage growth

1987-1996 1997-1999 2000-2006

Hong Kong 5.2 -0.8 4.7

Indonesia 7.1 -6.4 4.9
Korea 8.1 1.0 4.6
Malaysia 9.5 -0.8 4.7
Philippines 3.6 1.4 4.6
Singapore 9.2 2.8 4.6
Taiwan 7.2 5.1 3.3
Thailand 9.5 -3.3 5.1
East Asia* 7.6 0.0 4.5
* Excluding China and Japan

Source: IMF, CEIC, RBA

FIn 763: Lecture 2 22

 The recovery (2000)
• A number of factors contributed to the
rebound:
• strong growth of exports reflecting both the impact of substantial
currency depreciations on external competitiveness and the
surge in global demand for electronic equipment produced in the
region;
• restoration of more orderly financial market conditions, partly in
response to current account improvements and external
financing support;
• fiscal stimulus to support domestic demand;
• significant recoveries in regional stock markets, mainly in the
information technology and communications (ITC) sectors

FIn 763: Lecture 2 23

PART III. MULTINATIONAL FINANCIAL
MANAGEMENT: THEORY AND PRACTICE

• I. The MNC’s Policies

A. Main Objective of MNC: Maximize shareholder
wealth
• This means: making financing and investment decision that
add as much value as possible to the firm.
• Why do we focus on shareholder value?
• Shareholders are the legal owners of the firm and management
has a fiduciary obligation to act in their best interests
• Provides the best defense against hostile takeover: high share
price
• Easy to attract equity capital
B. Other Objectives Reflect Its Ability via affiliate
transfer mechanisms

FIn 763: Lecture 2 24

•
MFM: THEORY AND PRACTICE

 C. Mode of Transfer:
• Reflects freedom to select a variety of financial channels.
 D. Timing Flexibility:
• Most MNC have some flexibility in timing of fund flows.
 E. Value
• The ability to avoid national taxes has led to controversy.

FIn 763: Lecture 2 25

MFM: THEORY AND PRACTICE

 II. FUNCTIONS OF FINANCIAL

MANAGEMEN
• A. Two Basic Functions
1. Financing decision: Generating funds from external and
internal funds at the lowest long run cost possible
2. Investing decision: The allocation of funds over time in
such a way that shareholder wealth is maximized.
The interaction between financing and investment decision
is the key for maximizing the value of the firm

FIn 763: Lecture 2 26

MFM: THEORY AND PRACTICE

B. Additional Factors Facing the

MNC Executive
• 1. Political risk
• Example: Sudden expropriation
• 2. Economic risk
• Exchange and inflation risk
• International differences in tax rates
• Multiply money markets
• Currency control

FIn 763: Lecture 2 27

MFM: THEORY AND PRACTICE
 III. THEORETICAL FOUNDATIONS
 A. Useful Concepts from Financial Economics:
 A discipline that emphasizes the use of economic analysis to understand the
basic workings of financial markets, particularly the measurement and pricing of
risk and the intertemporal allocation of funds
 Three concepts arising in financial economics have particular importance in
international corporate finance:
 1. Arbitrage
• Definition: Traditionally has been defined as the purchase of assets or commodities in
one market for immediate resale on another in order to profit from price discrepancy
• Tax arbitrage
• Risk arbitrage
• The process of arbitrage insures market efficiency
 2. Market Efficiency
 3. Capital Asset Pricing
• CAPM and APT models
• Systematic (non diversifiable risk) versus unsystematic (diversifiable risk)

FIn 763: Lecture 2 28

MFM: THEORY AND PRACTICE

B. Importance of Total Risk

Although the message of the CAPM model is that only
systematic risk should be rewarded with risk
premium, this does not mean that the total risk is not
important to the value of the firm.
 1. Adverse Impact: lower sales and higher costs

• The probability of financial distress is determined by the

total risk and financial distress might be costly
 2. Justifies hedging activities of MNC
 3. Diversification reduces risk

FIn 763: Lecture 2 29

MFM: THEORY AND PRACTICE

IV. THE GLOBAL FINANCIAL MARKET

PLACE
A. Inter-linkage by Computers
B. Market Acts as A Global Referendum
Process Where : Currencies may rise
or fall

FIn 763: Lecture 2 30

 Assi gnment Two: Q-1
 1. Historically, the primary motive for U.S. multinationals
to produce abroad has been to
 a. lower costs
 b. respond more quickly to the marketplace
 c. avoid trade barriers
 d. gain tax benefits

FIn 763: Lecture 2 31

 Assi gnment Two: Q-2
 2. The value of good financial management is
___________ in the global markets because of the much
greater probability of market imperfections and multiple
tax rates.
 a. minimized
 b. neutralized
 c. enhanced
 d. arbitraged away

FIn 763: Lecture 2 32

 Assi gnment Two: Q-3
 3. ___________ are a recent category of multinationals
that seek out and invest in lower cost production sites
overseas.
 a. Cost minimizers
 b. Market seekers
 c. Raw-material seekers
 d. High tech firms

FIn 763: Lecture 2 33

 Assi gnment Two: Q-4
 4. Critics of the multinational corporation would not fault
its tendency to
a. shift production from one location to another in search of
lower costs
b. avoid taxes
c. cause balance of payments difficulties
d. engage in environmental protection measures

FIn 763: Lecture 2 34

 Assi gnment Two: Q-5
 According to the efficient market hypothesis, which one
of the following is NOT correct?
a.markets place a premium on the future
b.today’s stock price is the best predictor of tomorrow’s
stock price
c.stock prices reflect all available information
d.today’s stock price incorporates the past history of prices

FIn 763: Lecture 2 35

 Assi gnment Two: Q-6
 According to the capital asset pricing model
a.only the systematic component of risk affects the
required return
 b. foreign investments whose returns are uncorrelated
with the market's return should have a higher required
return than comparable domestic investments
 c. total risk of the investment is most relevant for small
to medium-sized firms
d.diversification is secondary to risk levels of the
investment

FIn 763: Lecture 2 36