International Financial Management

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International Financial Management

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Jeff Madura Florida Atlantic University

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Printed in United State of America Print Number: 01 Print Year: 2020

© 2021, 2018 Cengage Learning, Inc.International Financial Management, Fourteenth Edition Jeff Madura

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WCN: 02-300

 

 

iii

PART 1: The International Financial Environment 1 1 Multinational Financial Management: An Overview 3 2 International Flow of Funds 31 3 International Financial Markets 61 4 Exchange Rate Determination 101 5 Currency Derivatives 131

PART 2: Exchange Rate Behavior 185 6 Government Inf luence on Exchange Rates 187 7 International Arbitrage and Interest Rate Parity 227 8 Relationships among Inf lation, Interest Rates, and Exchange Rates 259

PART 3: Exchange Rate Risk Management 297 9 Forecasting Exchange Rates 299 10 Measuring Exposure to Exchange Rate Fluctuations 325 11 Managing Transaction Exposure 355 12 Managing Economic Exposure and Translation Exposure 393

PART 4: Long-Term Asset and Liability Management 413 13 Direct Foreign Investment 415 14 Multinational Capital Budgeting 435 15 International Corporate Governance and Control 475 16 Country Risk Analysis 501 17 Multinational Capital Structure and Cost of Capital 525 18 Long-Term Debt Financing 551

PART 5: Short-Term Asset and Liability Management 575 19 Financing International Trade 577 20 Short-Term Financing 595 21 International Cash Management 611

Appendix A: Answers to Self-Test Questions 643 Appendix B: Supplemental Cases 656 Appendix C: Using Excel to Conduct Analysis 676 Appendix D: International Investing Project 684 Appendix E: Discussion in the Boardroom 687 Appendix F: Use of Bitcoin to Conduct International Transactions 695 Glossary 698 Index 705

Brief Contents

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v

Preface, xvii

About the Author, xxiii

PART 1: The International Financial Environment 1

1: MuLTInATIonAL FInAncIAL MAnAgEMEnT: An ovERvIEw 3 1-1 Managing the MNC, 4

1-1a How Business Disciplines Are Used to Manage the MNC, 4 1-1b Agency Problems, 4 1-1c Management Structure of an MNC, 6

1-2 Why MNCs Pursue International Business, 8 1-2a Theory of Comparative Advantage, 8 1-2b Imperfect Markets Theory, 8 1-2c Product Cycle Theory, 9

1-3 Methods to Conduct International Business, 10 1-3a International Trade, 10 1-3b Licensing, 10 1-3c Franchising, 10 1-3d Joint Ventures, 10 1-3e Acquisitions of Existing Operations, 11 1-3f Establishment of New Foreign Subsidiaries, 11 1-3g Summary of Methods, 12

1-4 Valuation Model for an MNC, 13 1-4a Domestic Valuation Model, 13 1-4b Multinational Valuation Model, 14 1-4c Uncertainty Surrounding an MNC’s Cash Flows, 17 1-4d How Uncertainty Affects the MNC’s Cost of Capital, 20

1-5 Organization of the Text, 20

2: InTERnATIonAL FLow oF FundS 31 2-1 Balance of Payments, 31

2-1a Current Account, 31 2-1b Financial Account, 32 2-1c Capital Account, 33

2-2 Growth in International Trade, 34 2-2a Events That Increased Trade Volume, 34 2-2b Impact of Outsourcing on Trade, 36 2-2c Trade Volume among Countries, 37 2-2d Trend in U.S. Balance of Trade, 37

2-3 Factors Affecting International Trade Flows, 39 2-3a Cost of Labor, 40 2-3b Inf lation, 40 2-3c National Income, 40

Contents

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vi Contents

2-3d Credit Conditions, 41 2-3e Government Policies, 41 2-3f Exchange Rates, 46

2-4 International Capital Flows, 49 2-4a Factors Affecting Direct Foreign Investment, 49 2-4b Factors Affecting International Portfolio Investment, 50 2-4c Impact of International Capital Flows, 50

2-5 Agencies that Facilitate International Flows, 51 2-5a International Monetary Fund, 52 2-5b World Bank, 53 2-5c World Trade Organization, 53 2-5d International Finance Corporation, 54 2-5e International Development Association, 54 2-5f Bank for International Settlements, 54 2-5g OECD, 54 2-5h Regional Development Agencies, 54

3: InTERnATIonAL FInAncIAL MARkETS 61 3-1 Foreign Exchange Market, 61

3-1a History of Foreign Exchange, 62 3-1b Foreign Exchange Transactions, 63 3-1c Foreign Exchange Quotations, 68 3.1d Derivative Contracts in the Foreign Exchange Market, 72

3-2 International Money Market, 73 3-2a Dollar-Denominated Bank Accounts in Europe and Asia, 74 3-2b Money Market Interest Rates among Currencies, 74 3-2c Risk of International Money Market Securities, 75

3-3 International Credit Market, 76 3-3a Syndicated Loans in the Credit Market, 76

3-4 International Bond Market, 76 3-4a Eurobond Market, 77 3-4b Development of Other Bond Markets, 78 3-4c Risk of International Bonds, 78

3-5 International Stock Markets, 79 3-5a Issuance of Stock in Foreign Markets, 79 3-5b Issuance of Foreign Stock in the United States, 79 3-5c How Governance Varies among Stock Markets, 81 3-5d Integration of International Stock Markets and Credit Markets, 82

3-6 International Financial Market Crises, 82 3-6a Contagion Effects, 83

3-7 How Financial Markets Serve MNCs, 85 Appendix 3: Investing in International Financial Markets, 93

4: ExchAngE RATE dETERMInATIon 101 4-1 Measuring Exchange Rate Movements, 101 4-2 Exchange Rate Equilibrium, 102

4-2a Demand for a Currency, 103 4-2b Supply of a Currency for Sale, 104 4-2c Equilibrium Exchange Rate, 105 4-2d Change in the Equilibrium Exchange Rate, 106

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Contents v i i

4-3 Factors That Inf luence Exchange Rates, 108 4-3a Relative Inf lation Rates, 108 4-3b Relative Interest Rates, 110 4-3c Relative Income Levels, 111 4-3d Government Controls, 112 4-3e Expectations, 112 4-3f Interaction of Factors, 113 4-3g Inf luence of Factors across Multiple Currency Markets, 115 4-3h Impact of Liquidity on Exchange Rate Adjustments, 115

4-4 Movements in Cross Exchange Rates, 116 4-5 Capitalizing on Expected Exchange Rate Movements, 118

4-5a Institutional Speculation Based on Expected Appreciation, 118 4-5b Institutional Speculation Based on Expected Depreciation, 119 4-5c Speculation by Individuals, 119 4-5d Carry Trades, 120

5: cuRREncy dERIvATIvES 131 5-1 Forward Market, 131

5-1a How MNCs Use Forward Contracts, 131 5-1b Bank Quotations on Forward Rates, 132 5-1c Premium or Discount on the Forward Rate, 133 5-1d Movements in the Forward Rate over Time, 134 5-1e Offsetting a Forward Contract, 134 5-1f Using Forward Contracts for Swap Transactions, 135 5-1g Non-deliverable Forward Contracts, 135

5-2 Currency Futures Market, 136 5-2a Contract Specifications, 136 5-2b Trading Currency Futures, 137 5-2c Credit Risk of Currency Futures Contracts, 138 5-2d Comparing Currency Futures and Forward Contracts, 138 5-2e How MNCs Use Currency Futures, 139 5-2f Speculation with Currency Futures, 140

5-3 Currency Options Market, 142 5-3a Currency Options Exchanges, 142 5-3b Over-the-Counter Currency Options Market, 142

5-4 Currency Call Options, 142 5-4a Factors Affecting Currency Call Option Premiums, 143 5-4b How MNCs Use Currency Call Options, 144 5-4c Speculating with Currency Call Options, 145

5-5 Currency Put Options, 148 5-5a Factors Affecting Currency Put Option Premiums, 149 5-5b How MNCs Use Currency Put Options, 149 5-5c Speculating with Currency Put Options, 150

5-6 Other Forms of Currency Options, 152 5-6a Conditional Currency Options, 152 5-6b European Currency Options, 154

Appendix 5A: currency option Pricing, 165

Appendix 5B: currency option combinations, 169

Part 1 Integrative Problem: The International Financial Environment, 183

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viii Contents

PART 2: Exchange Rate Behavior 185

6: govERnMEnT InFLuEncE on ExchAngE RATES 187 6-1 Exchange Rate Systems, 187

6-1a Fixed Exchange Rate System, 187 6-1b Freely Floating Exchange Rate System, 189 6-1c Managed Float Exchange Rate System, 190 6-1d Pegged Exchange Rate System, 191 6-1e Dollarization, 197 6-1f Black Markets for Currencies, 197

6-2 A Single European Currency, 197 6-2a Monetary Policy in the Eurozone, 198 6-2b Impact on Firms in the Eurozone, 198 6-2c Impact on Financial Flows in the Eurozone, 199 6-2d Impact of a Eurozone Country Crisis on Other Eurozone Countries, 199 6-2e Impact of a Country Abandoning the Euro, 201

6-3 Direct Intervention, 202 6-3a Reasons for Direct Intervention, 202 6-3b The Direct Intervention Process, 203 6-3c Direct Intervention as a Policy Tool, 205 6-3d Speculating on Direct Intervention, 206

6-4 Indirect Intervention, 208 6-4a Government Control of Interest Rates, 208 6-4b Government Use of Foreign Exchange Controls, 209

Appendix 6: government Intervention during the Asian crisis, 217

7: InTERnATIonAL ARBITRAgE And InTEREST RATE PARITy 227 7-1 Locational Arbitrage, 227

7-1a Gains from Locational Arbitrage, 228 7-1b Realignment Due to Locational Arbitrage, 228

7-2 Triangular Arbitrage, 229 7-2a Gains from Triangular Arbitrage, 230 7-2b Realignment Due to Triangular Arbitrage, 232

7-3 Covered Interest Arbitrage, 233 7-3a Covered Interest Arbitrage Process, 233 7-3b Realignment Due to Covered Interest Arbitrage, 234 7-3c Arbitrage Example When Accounting for Spreads, 236 7-3d Covered Interest Arbitrage by Non-U.S. Investors, 236 7-3e Comparing Different Types of Arbitrage, 237

7-4 Interest Rate Parity (IRP), 238 7-4a Derivation of Interest Rate Parity, 238 7-4b Determining the Forward Premium, 239 7-4c Graphic Analysis of Interest Rate Parity, 241 7-4d Does Interest Rate Parity Hold?, 244 7-4e Considerations When Assessing Interest Rate Parity, 244

7-5 Variation in Forward Premiums, 245 7-5a Forward Premiums across Maturities, 245 7-5b Changes in Forward Premiums over Time, 246

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Contents i x

8: RELATIonShIPS AMong InFLATIon, InTEREST RATES, And ExchAngE RATES 259

8-1 Purchasing Power Parity (PPP), 259 8-1a Interpretations of Purchasing Power Parity, 259 8-1b Derivation of Purchasing Power Parity, 261 8-1c Using PPP to Estimate Exchange Rate Effects, 262 8-1d Graphic Analysis of Purchasing Power Parity, 263 8-1e Testing the Purchasing Power Parity Theory, 266 8-1f Why Deviations from PPP Exist, 267

8-2 International Fisher Effect, 268 8-2a Deriving a Country’s Expected Inf lation Rate, 268 8-2b Estimating the Expected Exchange Rate Movement, 270 8-2c Implications of the International Fisher Effect, 270 8-2d Derivation of the International Fisher Effect, 272 8-2e Graphic Analysis of the International Fisher Effect, 275 8-2f Testing the International Fisher Effect, 276 8-2g Limitations of IFE Theory, 277 8-2h Comparison of IRP, PPP, and IFE Theories, 277

Part 2 Integrative Problem: Exchange Rate Behavior, 288 Midterm Self-Exam, 289

PART 3: Exchange Rate Risk Management 297

9: FoREcASTIng ExchAngE RATES 299 9-1 Why Firms Forecast Exchange Rates, 299 9-2 Forecasting Techniques, 301

9-2a Technical Forecasting, 301 9-2b Fundamental Forecasting, 301 9-2c Market-Based Forecasting, 305 9-2d Mixed Forecasting, 307

9-3 Assessment of Forecast Performance, 309 9-3a Measurement of Forecast Error, 309 9-3b Forecast Errors among Time Horizons, 309 9-3c Forecast Errors among Currencies, 310 9-3d Comparing Forecast Errors among Forecast Techniques, 310 9-3e Graphic Evaluation of Forecast Bias, 311 9-3f Statistical Test of Forecast Bias, 313 9-3g Shifts in Forecast Bias over Time, 313

9-4 Accounting for Uncertainty Surrounding Forecasts, 313 9-4a Sensitivity Analysis Applied to Fundamental Forecasting, 314 9-4b Interval Forecasts, 314

10: MEASuRIng ExPoSuRE To ExchAngE RATE FLucTuATIonS 325 10-1 Relevance of Exchange Rate Risk, 325 10-2 Transaction Exposure, 326

10-2a Estimating “Net” Cash Flows in Each Currency, 328 10-2b Transaction Exposure of an MNC’s Portfolio, 329 10-2c Transaction Exposure Based on Value at Risk, 331

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x Contents

10-3 Economic Exposure, 334 10-3a Exposure to Foreign Currency Depreciation, 335 10-3b Exposure to Foreign Currency Appreciation, 336 10-3c Measuring Economic Exposure, 336

10-4 Translation Exposure, 339 10-4a Determinants of Translation Exposure, 339 10-4b Exposure of an MNC’s Stock Price to Translation Effects, 341

11: MAnAgIng TRAnSAcTIon ExPoSuRE 355 11-1 Policies for Hedging Transaction Exposure, 355

11-1a Hedging Most of the Exposure, 355 11-1b Selective Hedging, 355

11-2 Hedging Exposure to Payables, 356 11-2a Forward or Futures Hedge on Payables, 356 11-2b Money Market Hedge on Payables, 357 11-2c Call Option Hedge on Payables, 358 11-2d Comparison of Techniques for Hedging Payables, 360 11-2e Evaluating Past Decisions on Hedging Payables, 363

11-3 Hedging Exposure to Receivables, 363 11-3a Forward or Futures Hedge on Receivables, 364 11-3b Money Market Hedge on Receivables, 364 11-3c Put Option Hedge on Receivables, 364 11-3d Comparison of Techniques for Hedging Receivables, 367 11-3e Evaluating Past Decisions on Hedging Receivables, 370 11-3f Summary of Hedging Techniques, 370

11-4 Limitations of Hedging, 371 11-4a Limitation of Hedging an Uncertain Payment, 371 11-4b Limitation of Repeated Short-Term Hedging, 371

11-5 Alternative Methods to Reduce Exchange Rate Risk, 373 11-5a Leading and Lagging, 373 11-5b Cross-Hedging, 374 11-5c Currency Diversification, 374

Appendix 11: nontraditional hedging Techniques, 388

12: MAnAgIng EconoMIc ExPoSuRE And TRAnSLATIon ExPoSuRE 393 12-1 Managing Economic Exposure, 393

12-1a Assessing Economic Exposure, 393 12-1b Restructuring to Reduce Economic Exposure, 394 12-1c Limitations of Restructuring Intended to Reduce Economic Exposure, 398

12-2 A Case Study on Hedging Economic Exposure, 398 12-2a Savor Co.’s Assessment of Economic Exposure, 398 12-2b Using a Financing Strategy to Hedge Economic Exposure, 400

12-3 Managing Exposure to Fixed Assets, 400 12-4 Managing Translation Exposure, 401

12-4a Hedging Translation Exposure with Forward Contracts, 401 12-4b Limitations of Hedging Translation Exposure, 402

Part 3 Integrative Problem: Exchange Risk Management, 411

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Contents x i

PART 4: Long-Term Asset and Liability Management 413

13: dIREcT FoREIgn InvESTMEnT 415 13-1 Motives for Direct Foreign Investment, 415

13-1a Revenue-Related Motives, 415 13-1b Cost-Related Motives, 416 13-1c Comparing Benefits of DFI among Countries, 418

13-2 Benefits of International Diversification, 418 13-2a Diversification Analysis of International Projects, 420

13-3 Host Government Impact on DFI, 422 13-3a Incentives to Encourage DFI, 422 13-3b Barriers to DFI, 422

13-4 Assessing the Feasibility of Potential DFI, 424 13-4a A Case Study of Assessing Potential DFI, 424 13-4b Evaluating DFI Opportunities That Pass the First Screen, 426

14: MuLTInATIonAL cAPITAL BudgETIng 435 14-1 Subsidiary versus Parent Perspective, 435

14-1a Tax Differentials, 435 14-1b Restrictions on Remitted Earnings, 436 14-1c Exchange Rate Movements, 436 14-1d Summary of Factors That Distinguish the Parent Perspective, 436

14-2 Input for Multinational Capital Budgeting, 437 14-3 Multinational Capital Budgeting Example, 439

14-3a Background, 439 14-3b Analysis, 440

14-4 Other Factors to Consider, 442 14-4a Exchange Rate Fluctuations, 442 14-4b Inf lation, 445 14-4c Financing Arrangement, 446 14-4d Blocked Funds, 448 14-4e Uncertain Salvage Value, 450 14-4f Impact of Project on Prevailing Cash Flows, 451 14-4g Host Government Incentives, 451 14-4h Real Options, 452

14-5 Adjusting Project Assessment for Risk, 452 14-5a Risk-Adjusted Discount Rate, 452 14-5b Sensitivity Analysis, 453 14-5c Simulation, 456

Appendix 14: Incorporating International Tax Law in Multinational capital Budgeting, 468

15: InTERnATIonAL coRPoRATE govERnAncE And conTRoL 475 15-1 International Corporate Governance, 475

15-1a Governance by Board Members, 475 15-1b Governance by Institutional Investors, 476 15-1c Governance by Shareholder Activists, 476

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xii Contents

15-2 International Corporate Control, 477 15-2a Motives for International Acquisitions, 477 15-2b International Acquisition Process, 477 15-2c Barriers to International Corporate Control, 478 15-2d Model for Valuing a Foreign Target, 478

15-3 Factors Affecting Target Valuation, 480 15-3a Target-Specific Factors, 480 15-3b Country-Specific Factors, 481

15-4 A Case Study of Valuing a Foreign Target, 482 15-4a International Screening Process, 482 15-4b Estimating the Target’s Value, 483 15-4c Uncertainty Surrounding the Target’s Valuation, 484 15-4d Changes in Market Valuation of the Target over Time, 485

15-5 Disparity in Foreign Target Valuations, 486 15-5a Expected Cash Flows of the Foreign Target, 486 15-5b Exchange Rate Effects on Remitted Earnings, 486 15-5c Required Return of Acquirer, 487

15-6 Other Corporate Control Decisions, 487 15-6a International Partial Acquisitions, 487 15-6b International Acquisitions of Privatized Businesses, 488 15-6c International Divestitures, 488

15-7 Corporate Control Decisions as Real Options, 490 15-7a Call Option on Real Assets, 490 15-7b Put Option on Real Assets, 491

16: counTRy RISk AnALySIS 501 16-1 Country Risk Characteristics, 501

16-1a Political Risk Characteristics, 501 16-1b Financial Risk Characteristics, 504

16-2 Measuring Country Risk, 505 16-2a Techniques for Assessing Country Risk, 506 16-2b Deriving a Country Risk Rating, 507 16-2c Comparing Risk Ratings among Countries, 509

16-3 Incorporating Risk in Capital Budgeting, 510 16-3a Adjustment of the Discount Rate, 510 16-3b Adjustment of the Estimated Cash Flows, 510 16-3c Analysis of Existing Projects, 513

16-4 Preventing Host Government Takeovers, 514 16-4a Use a Short-Term Horizon, 514 16-4b Rely on Unique Supplies or Technology, 514 16-4c Hire Local Labor, 514 16-4d Borrow Local Funds, 514 16-4e Purchase Insurance, 515 16-4f Use Project Finance, 515

17: MuLTInATIonAL cAPITAL STRucTuRE And coST oF cAPITAL 525 17-1 Components of Capital, 525

17-1a Retained Earnings, 525 17-1b Sources of Debt, 526 17-1c External Sources of Equity, 527

17-2 The MNC’s Capital Structure Decision, 528 17-2a Inf luence of Corporate Characteristics, 529

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Contents x i i i

17-2b Inf luence of Host Country Characteristics, 529 17-2c Response to Changing Country Characteristics, 530

17-3 Subsidiary versus Parent Capital Structure Decisions, 531 17-3a Impact of Increased Subsidiary Debt Financing, 531 17-3b Impact of Reduced Subsidiary Debt Financing, 531 17-3c Limitations in Offsetting a Subsidiary’s Leverage, 532

17-4 Multinational Cost of Capital, 532 17-4a MNC’s Cost of Debt, 532 17-4b MNC’s Cost of Equity, 532 17-4c Estimating an MNC’s Cost of Capital, 533 17-4d Comparing Costs of Debt and Equity, 533 17-4e Cost of Capital for MNCs versus Domestic Firms, 534 17-4f Cost-of-Equity Comparison Using the CAPM, 536

17-5 Cost of Capital Across Countries, 537 17-5a Country Differences in the Cost of Debt, 538 17-5b Country Differences in the Cost of Equity, 540

18: Long-TERM dEBT FInAncIng 551 18-1 Debt Denomination Decisions of Foreign Subsidiaries, 551

18-1a Foreign Subsidiary Borrows Its Local Currency, 551 18-1b Foreign Subsidiary Borrows Dollars, 553

18-2 Debt Denomination Analysis: A Case Study, 553 18-2a Analyzing Debt Denomination Alternatives, 554

18-3 Strategies to Hedge Foreign Financing, 555 18-3a Using Currency Swaps, 555 18-3b Using Parallel Loans, 556

18-4 Debt Maturity Decision, 559 18-4a Assessment of the Yield Curve, 559 18-4b Financing Costs of Loans with Different Maturities, 560

18-5 Fixed-Rate versus Floating-Rate Debt Decision, 561 18-5a Financing Costs of Fixed-Rate versus Floating-Rate Loans, 561 18-5b Hedging Interest Payments with Interest Rate Swaps, 562

Part 4 Integrative Problem: Long-Term Asset and Liability Management, 573

PART 5: Short-Term Asset and Liability Management 575

19: FInAncIng InTERnATIonAL TRAdE 577 19-1 Payment Methods for International Trade, 577

19-1a Prepayment, 577 19-1b Letters of Credit, 578 19-1c Drafts, 580 19-1d Consignment, 581 19-1e Open Account, 581 19-1f Impact of the Credit Crisis on Payment Methods, 581

19-2 Trade Finance Methods, 581 19-2a Accounts Receivable Financing, 582 19-2b Factoring, 582 19-2c Letters of Credit, 583 19-2d Banker’s Acceptances, 583 19-2e Medium-Term Capital Goods Financing (Forfaiting), 586 19-2f Countertrade, 586

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xiv Contents

19-3 Agencies that Facilitate International Trade, 587 19-3a Export-Import Bank of the United States, 587 19-3b Private Export Funding Corporation, 589 19-3c Overseas Private Investment Corporation, 589

20: ShoRT-TERM FInAncIng 595 20-1 Sources of Foreign Financing, 595

20-1a Internal Short-Term Financing, 595 20-1b External Short-Term Financing, 596

20-2 Financing with a Foreign Currency, 596 20-2a Motive for Financing with a Foreign Currency, 597 20-2b Potential Cost Savings from Financing with a Foreign Currency, 597 20-2c Risk of Financing with a Foreign Currency, 598 20-2d Hedging the Foreign Currency Borrowed, 599 20-2e Reliance on the Forward Rate for Forecasting, 600 20-2f Use of Probability Distributions to Enhance the Financing Decision, 601

20-3 Financing with a Portfolio of Currencies, 602

21: InTERnATIonAL cASh MAnAgEMEnT 611 21-1 Multinational Working Capital Management, 611

21-1a Subsidiary Expenses, 611 21-1b Subsidiary Revenue, 612 21-1c Subsidiary Dividend Payments, 612 21-1d Subsidiary Liquidity Management, 612

21-2 Centralized Cash Management, 612 21-2a Accommodating Cash Shortages, 613

21-3 Optimizing Cash Flows, 614 21-3a Accelerating Cash Inf lows, 614 21-3b Minimizing Currency Conversion Costs, 614 21-3c Managing Blocked Funds, 616 21-3d Managing Intersubsidiary Cash Transfers, 617

21-4 Investing Excess Cash, 617 21-4a Benefits of Investing in a Foreign Currency, 617 21-4b Risk of Investing in a Foreign Currency, 618 21-4c Hedging the Investment in a Foreign Currency, 619 21-4d Break-Even Point from Investing in a Foreign Currency, 620 21-4e Using a Probability Distribution to Enhance the Investment Decision, 621 21-4f Investing in a Portfolio of Currencies, 622 21-4g Dynamic Hedging, 624

Part 5 Integrative Problem: Short-Term Asset and Liability Management, 631 Final Self-Exam, 633

Appendix A: Answers to Self-Test Questions, 643

Appendix B: Supplemental cases, 656

Appendix c: using Excel to conduct Analysis, 676

Appendix d: International Investing Project, 684

Appendix E: discussion in the Boardroom, 687

Appendix F: use of Bitcoin to conduct International Transactions, 695

glossary, 698

Index, 705

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xv

Dedication

This text is dedicated to Best Friends Animal Society in Kanab, Utah, for its commitment to, compassion for, and care of more than 1,500 animals, many of which were previously homeless. Best Friends has established an ambitious campaign to save all healthy dogs and cats in the United States by 2025—that is, to prevent healthy cats and dogs from being euthanized due to excessive population.

Most of the royalties the author receives from this edition of the text will be invested in a fund that will ultimately be donated to Best Friends Animal Society and other humane societies. In the last several years, this fund has donated more than $500,000 to Best Friends to support a new healthcare facility for Best Friends, sponsor a Public Broadcasting Service (PBS) documentary on the efforts of Best Friends to help animal societies, save dogs that were abandoned during Hurricane Harvey in Houston during 2017, and create an online information network in 2019 for people who want to help dogs. This fund has also donated more than $100,000 to other animal care societies, including Friends of Greyhounds (Fort Lauderdale, FL), Florida Humane Society (Pompano Beach, FL), Greyhound Pets of America in Central Florida (Melbourne, FL), Tri-County Humane Society (Boca Raton, FL), and Doris Day Animal League (Washington, DC).

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xvii

Preface

Businesses evolve into multinational corporations (MNCs) so that they can capitalize on international opportunities. Their financial managers must be able to evaluate the inter- national environment, recognize opportunities, implement strategies, assess exposure to risk, and manage that risk. The MNCs most capable of responding to changes in the inter- national financial environment will be rewarded. The same can be said for the students today, who may become the future managers of MNCs.

Intended Market International Financial Management, 14th Edition, presumes an understanding of basic corporate finance. It is suitable for both undergraduate- and master’s-level courses in inter- national financial management. For master’s courses, the more challenging questions, problems, and cases in each chapter are recommended, along with special projects.

organization of the Text International Financial Management, 14th Edition, is organized to provide a background on the international environment and then to focus on the managerial aspects from a cor- porate perspective. Managers of MNCs will need to understand the environment before they can manage within it.

The first two parts of the text establish the necessary macroeconomic framework. Part 1 (Chapters 1 through 5) introduces the major markets that facilitate international business. Part 2 (Chapters 6 through 8) describes relationships between exchange rates and economic variables and explains the forces that inf luence these relationships.

The rest of the text develops a microeconomic framework with a focus on the manage- rial aspects of international financial management. Part 3 (Chapters 9 through 12) explains the measurement and management of exchange rate risk. Part 4 (Chapters 13 through 18) describes the management of long-term assets and liabilities, including motives for direct foreign investment, multinational capital budgeting, country risk analysis, and capital structure decisions. Part 5 (Chapters 19 through 21) concentrates on the MNC’s man- agement of short-term assets and liabilities, including trade financing, other short-term financing, and international cash management.

Each chapter is self-contained so that professors can use classroom time to focus on the more comprehensive topics while relying on the text to cover other concepts. The management of long-term assets (Chapters 13 through 16 on direct foreign investment, multinational capital budgeting, multinational restructuring, and country risk analysis) is covered before the management of long-term liabilities (Chapters 17 and 18 on capital structure and debt financing) because short-term managerial decisions are intended to facilitate the long-term strategies that have been implemented. For professors who prefer to cover the MNC’s management of short-term assets and liabilities before the management of long-term assets and liabilities, the parts can be rearranged because they are self-contained.

Professors may limit their coverage of chapters in some sections where they believe the text concepts are covered by other courses or do not need additional attention beyond that found in the text. For example, they may give less attention to the chapters in

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xviii Preface

Part 2 (Chapters 6 through 8) if their students take a course in international economics. If professors focus on the main principles, they may limit their coverage of Chapters 5, 15, 16, and 18. In addition, they may give less attention to Chapters 19 through 21 if they believe that the text description does not require elaboration.

Approach of the Text International Financial Management, 14th Edition, focuses on financial management decisions that maximize the value of multinational corporations. The text offers a variety of methods to reinforce key concepts, allowing instructors to select those methods and features that best fit their teaching styles.

■■ Part-Opening Diagram. A diagram is provided at the beginning of each part to illustrate how the key concepts covered in that part are related.

■■ Objectives. A bulleted list at the beginning of each chapter identifies the key concepts in that chapter.

■■ Examples. The key concepts are thoroughly described in the chapter and supported by examples.

■■ Web Links. Websites that offer useful related information regarding key concepts are provided in each chapter.

■■ Summary. A bulleted list at the end of each chapter summarizes the key concepts. This list corresponds to the list of objectives at the beginning of the chapter.

■■ Point/Counterpoint. A controversial issue is introduced, along with opposing arguments, and students are asked to offer their opinions.

■■ Self-Test Questions. A “Self-Test” at the end of each chapter challenges students on the key concepts. The answers to these questions are provided in Appendix A.

■■ Questions and Applications. A substantial set of questions and other applications at the end of each chapter test the student’s knowledge of the key concepts in the chapter.

■■ Critical Thinking Question. At the end of each chapter, a critical thinking question challenges students to use their skills to write a short essay on a key topic discussed in the chapter.

■■ Continuing Case. At the end of each chapter, the continuing case allows students to use the key concepts to solve problems experienced by a firm called Blades, Inc. (a producer of roller blades). By working on cases related to the same MNC over a school term, students recognize how an MNC’s decisions are integrated.

■■ Small Business Dilemma. The Small Business Dilemma at the end of each chapter places students in a position where they must use concepts introduced in the chapter to make decisions about a small MNC called Sports Exports Company.

■■ Internet/Excel Exercises. At the end of each chapter are exercises that expose the students to applicable information available at various websites, enable the applica- tion of Excel to related topics, or both.

■■ Integrative Problem. An integrative problem at the end of each part weaves together the key concepts introduced in the various chapters within that part.

■■ Midterm and Final Examinations. A midterm self-exam is provided at the end of Chapter 8, which focuses on international macro and market conditions (Chapters 1 through 8). A final self-exam is provided at the end of Chapter 21, which focuses on the managerial chapters (Chapters 9 through 21). Students can compare their answers to those in the answer key provided.

■■ Supplemental Cases. Supplemental cases allow students to apply chapter concepts to a specific situation of an MNC. All supplemental cases are located in Appendix B.

■■ Running Your Own MNC. This project allows each student to create a small international business and apply key concepts from each chapter to run the business

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Preface x i x

throughout the school term. The project is available on the textbook companion site (see the “Online Resources” section).

■■ International Investing Project. This project (located in Appendix D) allows students to simulate investing in stocks of MNCs and foreign companies; it requires them to assess how the values of these stocks change during the school term in response to international economic conditions. The project is also available on the textbook companion site (see the “Online Resources” section).

■■ Discussion in the Boardroom. Located in Appendix E, this project allows students to play the role of managers or board members of a small MNC that they created and to make decisions about that firm. This project is also available on the textbook companion site (see the “Online Resources” section).

■■ The wide variety of end-of-chapter and end-of-part exercises and cases offer many opportunities for students to engage in teamwork, decision making, and communication.

changes to this Edition All chapters in the 14th edition have been updated to include recent developments in inter- national financial markets, and in the tools used to manage MNCs. In particular, more emphasis has been given to the following concepts:

■■ Sources of uncertainty when attempting to value an MNC ■■ Tradeoffs on any international trade policy ■■ Implicit barriers to entry in some international markets ■■ Challenges faced by central banks that attempt to manipulate their local currency’s value ■■ Dilemmas experienced by some countries that participate in European Union

(which led to Brexit) ■■ Theory versus reality for relationships between the Fisher effect, purchasing power

parity (PPP), and the international Fisher effect (IFE) ■■ Using the value at risk method to assess exchange rate risk ■■ Using sensitivity analysis to account for uncertainty ■■ Tradeoffs from hedging exchange rate risk ■■ Tradeoffs involved in international restructuring ■■ International market for corporate control ■■ Properly accounting for country risk in international capital budgeting ■■ How an MNC’s capital structure used in a foreign country depends on that

country’s characteristics ■■ How an MNC’s cost of capital used in a foreign country depends on that country’s

characteristics ■■ MNCs’ use of foreign debt as a long-term hedge against exchange rate risk

new to this Edition: MindTap MindTap™, Cengage’s fully online, highly personalized learning experience combines readings, multimedia activities, and assessments into a singular Learning Path. MindTap™ guides students through their course with ease and engagement with a learning path that includes an Interactive Chapter Reading, Algorithmic Practice Problems, and Homework Assignments powered by Aplia. These homework problems include rich explanations and instant grading, with opportunities to try another algorithmic version of the prob- lem to bolster confidence with problem solving. Instructors can personalize the Learning Path for their students by customizing the robust suite of resources and adding their own content via apps that integrate into the MindTap™ framework seamlessly with Learning Management Systems.

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xx Preface

Supplements to the Text To access student and instructor resources, please visit http://www.cengage.com/finance /madura/ifm/14e.

Instructor Supplements The following supplements are available to instructors.

■■ Instructor’s Manual. Revised by the author, the Instructor’s Manual contains the chapter theme, topics to stimulate class discussion, and answers to end-of-chapter Questions, Case Problems, Continuing Cases (Blades, Inc.), Small Business Dilemmas, Integrative Problems, and Supplemental Cases.

■■ Test Bank. The expanded test bank, which has also been revised by the author, contains a large set of questions in multiple-choice or true/false format, including content questions as well as problems.

■■ Cognero™ Test Bank. Cengage Learning Testing Powered by Cognero™ is a f lexible online system that allows you to author, edit, and manage test bank content from multiple Cengage Learning solutions; create multiple test versions in an instant; deliver tests from your learning management system (LMS), your classroom, or wherever you want. The Cognero™ Test Bank contains the same questions that are found in the Microsoft® Word Test Bank. All question content is now tagged according to Tier I (Business Program Interdisciplinary Learning Outcomes) and Tier II (Finance-specific) standards topic, Bloom’s Taxonomy, and difficulty level.

■■ PowerPoint Slides. The PowerPoint Slides provide a solid guide for organizing lectures. In addition to the regular notes slides, a separate set of exhibit-only PPTs is available.

Additional course Tools ■■ Cengage Learning Custom Solutions. Whether you need print, digital, or hybrid course

materials, Cengage Learning Custom Solutions can help you create your perfect learning solution. Draw from Cengage Learning’s extensive library of texts and collec- tions, add your own original work, and/or create customized media and technology to match your learning and course objectives. Our editorial team will work with you through each step, allowing you to concentrate on the most important thing—your students. Learn more about all our services at www.cengage.com/custom.

Acknowledgments Several professors reviewed previous versions of this text and inf luenced its content and organization. They are acknowledged below in alphabetical order.

Tom Adamson, Midland University Raj Aggarwal, University of Akron Richard Ajayi, University of Central

Florida Alan Alford, Northeastern University Yasser Alhenawi, University of Evansville H. David Arnold, Auburn University Robert Aubey, University of Wisconsin

Bruce D. Bagamery, Central Washington University

James C. Baker, Kent State University Gurudutt Baliga, University of Delaware Laurence J. Belcher, Stetson University Richard Benedetto, Merrimack College Bharat B. Bhalla, Fairfield University Rahul Bishnoi, Hofstra University

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Preface x x i

P. R. Chandy, University of North Texas Prakash L. Dheeriya, California State

University–Dominguez Hills Benjamin Dow, Southeast Missouri State

University Margaret M. Forster, University of Notre

Dame Lorraine Gilbertson, Webster University Charmaine Glegg, East Carolina

University Anthony Yanxiang Gu, SUNY–Geneseo Anthony F. Herbst, Suffolk University Chris Hughen, University of Denver Abu Jalal, Suffolk University Steve A. Johnson, University of Texas–El

Paso Manuel L. Jose, University of Akron Dr. Joan C. Junkus, DePaul University Rauv Kalra, Morehead State University Ho-Sang Kang, University of Texas–Dallas Mohammad A. Karim, University of

Texas–El Paso Frederick J. Kelly, Seton Hall University Robert Kemp, University of Virginia Coleman S. Kendall, University of Illinois

Chicago Dara Khambata, American University Chong-Uk Kim, Sonoma State University Doseong Kim, University of Akron Elinda F. Kiss, University of Maryland Thomas J. Kopp, Siena College Suresh Krishman, Pennsylvania State

University Merouane Lakehal-Ayat, St. John Fisher

College Duong Le, University of Arkansas–Little

Rock Boyden E. Lee, New Mexico State

University Jeong W. Lee, University of North Dakota Michael Justin Lee, University of

Maryland Sukhun Lee, Loyola University Chicago Richard Lindgren, Graceland University Charmen Loh, Rider University Carl Luft, DePaul University Ed Luzine, Union Graduate College K. Christopher Ma, KCM Investment Co. Davinder K. Malhotra, Philadelphia

University

Richard D. Marcus, University of Wisconsin–Milwaukee

Anna D. Martin, St. John’s University Leslie Mathis, University of Memphis Ike Mathur, Southern Illinois University Wendell McCulloch Jr., California State

University–Long Beach Carl McGowan, University of

Michigan–Flint Fraser McHaffie, Marietta College Edward T. Merkel, Troy University Stuart Michelson, Stetson University Scott Miller, Pepperdine University Jose Francisco Moreno, University of the

Incarnate Word Penelope E. Nall, Gardner-Webb University Duc Anh Ngo, University of Texas–El Paso Srinivas Nippani, Texas A&M University Andy Noll, St. Catherine University Vivian Okere, Providence College Edward Omberg, San Diego State

University Prasad Padmanabhan, San Diego State

University Ali M. Parhizgari, Florida International

University Anne Perry, American University Rose M. Prasad, Central Michigan

University Larry Prather, East Tennessee State

University Abe Qastin, Lakeland College Frances A. Quinn, Merrimack College Mitchell Ratner, Rider University David Rayome, Northern Michigan

University S. Ghon Rhee, University of Rhode Island William J. Rieber, Butler University Mohammad Robbani, Alabama A&M

University Ashok Robin, Rochester Institute of

Technology Alicia Rodriguez de Rubio, University of

the Incarnate Word Tom Rosengarth, Westminster College Atul K. Saxena, Georgia Gwinnett College Kevin Scanlon, University of Notre Dame Michael Scarlatos, CUNY–Brooklyn

College Jeff Schultz, Christian Brothers University

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xxii Preface

Jacobus T. Severiens, Kent State University Vivek Sharma, University of

Michigan–Dearborn Peter Sharp, California State

University–Sacramento Dilip K. Shome, Virginia Tech University Joseph Singer, University of Missouri–

Kansas City Naim Sipra, University of Colorado–Denver Jacky So, Southern Illinois

University–Edwardsville Luc Soenen, California Polytechnic State

University–San Luis Obispo Ahmad Sohrabian, California State

Polytechnic University–Pomona Carolyn Spencer, Dowling College Angelo Tarallo, Ramapo College Amir Tavakkol, Kansas State University G. Rodney Thompson, Virginia Tech Stephen G. Timme, Georgia State

University Daniel L. Tompkins, Niagara University Niranjan Tripathy, University of North

Texas Eric Tsai, Temple University

Joe Chieh-chung Ueng, University of St. Thomas

Mo Vaziri, California State University Mahmoud S. Wahab, University of

Hartford Ralph C. Walter III, Northeastern Illinois

University Hong Wan, SUNY–Oswego Elizabeth Webbink, Rutgers University Ann Marie Whyte, University of Central

Florida Marilyn Wiley, University of North Texas Rohan Williamson, Georgetown

University Larry Wolken, Texas A&M University Glenda Wong, De Paul University Shengxiong Wu, Indiana

University–South J. Jimmy Yang, Oregon State University Bend Mike Yarmuth, Sullivan University Yeomin Yoon, Seton Hall University David Zalewski, Providence College Emilio Zarruk, Florida Atlantic University Stephen Zera, California State University–

San Marcos

In addition, many friends and colleagues offered useful suggestions that inf luenced the content and organization of this edition, including Kevin Brady (St. Thomas University), Kien Cao (Foreign Trade University), Inga Chira (California State University, Northridge), Jeff Coy (Penn State—Erie), Sean Davis (University of North Florida), Luis Garcia- Feijoo (Florida Atlantic University), Dan Hartnett, Victor Kalafa, Sukhun Lee (Loyola University Chicago), Pat Lewis, Marek Marciniak (West Chester University), Thanh Ngo (East Carolina University), Arjan Premti (University of Wisconsin—Whitewater), Jurica Susnjara (Texas State University), and Nik Volkov (Mercer University).

I also benefited from the input of many business owners and managers I have met outside the United States who have been willing to share their insight about international financial management.

I appreciate the help and support from the people at Cengage, including Aaron Arnsparger (Sr. Product Manager), Christopher Walz (Marketing Manager), Christopher Valentine (Content Manager), and Brandon Foltz (Learning Designer).

Jeff Madura Florida Atlantic University

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xxiii

About the Author

Dr. Jeff Madura is presently Emeritus Professor of Finance at Florida Atlantic University. He has written several successful finance texts, including Financial Markets and Institutions (now in its 13th edition). His research on international finance has been published in numerous journals, including Journal of Financial and Quantitative Analysis; Journal of Banking and Finance; Journal of Money, Credit and Banking; Journal of International Money and Finance; Financial Management; Journal of Financial Research; Financial Review; Journal of International Financial Markets, Institutions, and Money; Global Finance Journal; International Review of Financial Analysis; and Journal of Multinational Financial Management. Dr. Madura has received multiple awards for excellence in teaching and research, and he has served as a consultant for international banks, securities firms, and other multinational corporations. He served as a director for the Southern Finance Association and the Eastern Finance Association, and he is also former president of the Southern Finance Association.

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P a r t 1

The International Financial Environment

Part 1 (Chapters 1 through 5) provides an overview of the multinational corporation (MNC) and the environment in which it operates. Chapter 1 explains the goals of the MNC, along with the motives and risks of international business. Chapter 2 describes the international f low of funds between countries. Chapter 3 describes the interna- tional financial markets and explains how these markets facilitate ongoing operations. Chapter 4 explains how exchange rates are determined, and Chapter 5 provides back- ground on the currency futures and options markets. Managers of MNCs must under- stand the international environment described in these chapters so that they can make proper decisions.

Product Markets

Foreign Exchange Markets

Subsidiaries International

Financial Markets

Investing and FinancingExporting and Importing

Dividend Remittance

and Financing

Multinational Corporation (MNC)

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3

Chapter ObjeCtives

The specific objectives of this chapter are to:

■■ Identify the management goal and organizational structure of the MNC.

■■ Describe the key theories about why MNCs engage in international business.

■■ Explain the common methods used to conduct international business.

■■ Provide a model for valuing the MNC.

Multinational corporations (MNCs) are defined as firms that engage in some form of international business. Their managers conduct international financial management, which involves international investing and financing decisions that are intended to maximize the value of the MNC. The goal of these managers is to maximize their firm’s value, which is the same goal pursued by managers employed by strictly domestic companies.

Initially, firms may merely attempt to export products to a certain country or import supplies from a foreign manufacturer. Over time, however, many of these firms recognize additional foreign opportunities and even- tually establish subsidiaries in foreign countries. DowDuPont, IBM, Nike, and many other U.S. firms have more than half of their assets in foreign countries. Many technology firms, such as Apple, Facebook, and Twitter, expand overseas in an effort to capitalize on their technology advantages.

Some businesses, such as ExxonMobil, Fortune Brands, and Colgate- Palmolive, commonly generate more than half of their sales in foreign countries. Many smaller U.S. firms such as Ferro (Ohio) generate more than 20 percent of their sales in foreign markets. Likewise, some smaller private U.S. firms such as Republic of Tea (California) and Magic Seasoning Blends (Louisiana) generate a substantial percentage of their sales in nondomestic markets. In fact, 75 percent of U.S. firms that export products or services have fewer than 100 employees.

International financial management is important even to companies that have no international business. These companies must recognize how their foreign competitors will be influenced by movements in exchange rates, foreign interest rates, labor costs, and inflation. Such economic characteristics can affect the foreign competitors’ costs of production and pricing policies.

This chapter provides background on the goals, motives, and valuation of a multinational corporation.

1 Multinational Financial Management: An Overview

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1-1 Managing the MNC The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers employed by the MNC are expected to make decisions that will maximize the stock price, thereby serving the shareholders’ interests. Some publicly traded MNCs based outside the United States may have additional goals, such as satisfying their respective govern- ments, creditors, or employees. Nevertheless, these MNCs place greater emphasis on their primary goal of satisfying shareholders; that way, the firm can more easily obtain funds from them to support its operations. Even in developing countries (for example, Bulgaria and Vietnam) that have just recently encouraged the development of business enterprise, managers of firms must serve shareholder interests if they hope to obtain funding from investors.

The focus of this text is MNCs whose parents wholly own any foreign subsidiaries, which means that the U.S. parent is the sole owner of the subsidiaries. This is the most common form of ownership of U.S.-based MNCs, and it gives financial managers throughout the firm the single goal of maximizing the entire MNC’s value (rather than the value of any particular subsidiary). The concepts in this text also generally apply to MNCs based in countries other than the United States.

1-1a How Business Disciplines Are Used to Manage the MNC Various business disciplines are integrated to manage the MNC in a manner that maxi- mizes shareholder wealth. Management develops strategies that will motivate and guide employees who work in an MNC and to organize resources so that they can efficiently produce products or services. Marketing seeks to increase consumer awareness about the products and to recognize changes in consumer preferences. Accounting and information systems record financial information about revenue and expenses of the MNC, which can be used to report financial information to investors and to evaluate the outcomes of various strategies implemented by the MNC. Finance makes investment and financing decisions for the MNC. Common finance decisions include the following:

■■ Whether to pursue new business in a particular country ■■ Whether to expand business in a particular country ■■ How to finance expansion in a particular country ■■ Whether to discontinue operations in a particular country

These finance decisions for each MNC are partially inf luenced by the other business discipline functions. The decision to pursue new business in a particular country depends on a comparison of the costs and potential benefits of expansion. The potential benefits of such new business ref lect both the expected consumer interest in the products to be sold (marketing function) and the expected cost of the resources needed to pursue the new business (management function). Financial managers rely on financial data provided by the accounting and information systems functions.

1-1b Agency Problems Managers of an MNC may sometimes make decisions that conf lict with the firm’s goal of  maximizing shareholder wealth. For example, a manager’s decision to establish a subsidiary in one location versus another may be based on the location’s appeal to the manager rather than on its potential benefits to shareholders. This conf lict of goals between a firm’s managers and shareholders is often referred to as the agency problem.

4 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 5

The costs of ensuring that managers maximize shareholder wealth (referred to as agency costs) are typically larger for MNCs than they are for purely domestic firms, for several reasons. First, MNCs with subsidiaries scattered around the world may experi- ence larger agency problems because monitoring the managers of distant subsidiaries in foreign countries is more difficult. Second, foreign subsidiary managers who are raised in different cultures may not follow uniform goals. Some of them may believe that the first priority should be to serve their respective employees. Third, the sheer size of the larger MNCs can create significant agency problems, because it complicates the monitoring of all managers.

Two years ago, Seattle Co. (based in the United States) established a subsidiary in Singapore so that it could expand its business there. It hired a few managers in Singapore to manage the subsidiary. During the last two years, sales generated by the subsidiary have not grown. Even so, the managers in Singapore hired several employees to do the work that they were assigned to do, and the subsidiary has incurred losses recently because it is so poorly managed. The managers of the parent company in the United States have not closely monitored the subsidiary in Singapore because it is so far away and because they trusted the managers there. Now they realize that there is an agency problem, and the management in Singapore must be more closely monitored.■●

ExamplE

Lack of monitoring can lead to substantial losses for MNCs. The large New York–based bank JPMorgan Chase & Co. lost at least $6.2 billion and had to pay more than $1 billion in fines and penalties after a trader in its office in London made extremely risky trades. The subsequent investigation revealed that the bank had maintained poor internal controls and failed to provide proper oversight of its employees.

Parent Control of Agency Problems The parent corporation of an MNC may be able to prevent most agency problems with proper governance. The parent should clearly communicate the goals for each subsidiary to ensure that all of them focus on maximizing the value of the MNC, rather than the value of their respective subsidiaries. The parent can oversee subsidiary decisions to check whether each subsidiary’s managers are satisfying the MNC’s goals. The parent also can implement compensation plans that reward those managers who satisfy the MNC’s goals. One commonly used incentive is to provide man- agers with the MNC’s stock (or options to buy that stock at a fixed price) as part of their compensation; thus, the subsidiary managers benefit directly from a higher stock price when they make decisions that enhance the MNC’s value.

ExamplE When Seattle Co. (from the previous example) recognized the agency problems with its Singapore subsidiary, it created incentives for the managers of the subsidiary that aligned with the parent’s goal of maximizing shareholder wealth. Specifically, it set up a compensation system whereby each manager’s annual bonus is based on the subsidiary’s earnings. This encouraged the managers to reduce expenses so that the subsidiary would generate higher earnings and they would, in turn, receive a bonus. ●

Corporate Control of Agency Problems In some cases, agency problems  can occur because the goals of the entire management of the MNC are not focused on maxi- mizing shareholder wealth. Various forms of corporate control can help prevent these agency problems and induce managers to make decisions that satisfy the MNC’s shareholders. If managers make poor decisions that reduce the MNC’s value, then another firm might acquire it at this lower price; the new owner would then probably remove the weak managers. Moreover, institutional investors (for example, mutual and pension funds)

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with large holdings of an MNC’s stock have some inf luence over management and may complain to the board of directors if managers are making poor decisions. Institutional investors may seek to enact changes, including removal of high-level managers or even board members, in a poorly performing MNC. Such investors may also band together to demand changes in an MNC, as they know that the firm would not want to lose all of its major shareholders.

How SOX Improved Corporate Governance of MNCs One limitation of the corporate control process is that investors rely on reports by the firm’s own managers for information. If managers are serving themselves rather than the investors, they may exag- gerate their performance. Many well-known examples (such as Enron and WorldCom) can be cited of large MNCs that were able to alter their financial reporting and hide problems from investors.

Enacted in 2002, the Sarbanes-Oxley Act (SOX) ensures a more transparent process for managers to report on the productivity and financial condition of their firm. It requires firms to implement an internal reporting process that can be easily monitored by execu- tives and the board of directors. Methods used by MNCs to improve their internal control process may include the following:

■■ 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 ■■ Speeding the process by which all departments and subsidiaries access needed data ■■ Making executives more accountable for financial statements by personally

verifying their accuracy

These systems make it easier for a firm’s board members to monitor the financial reporting process. In this way, SOX reduced the likelihood that managers of a firm can manipulate the reporting process and, therefore, improved the accuracy of financial infor- mation for existing and prospective investors.

1-1c Management Structure of an MNC The magnitude of agency costs can vary with the MNC’s management style. A centralized management style, as illustrated in the top section of Exhibit 1.1, can reduce agency costs because it allows managers of the parent to control foreign subsidiaries, which in turn reduces the power of subsidiary managers. However, the parent’s managers may make poor decisions for the subsidiary if they are less informed than the subsidiary’s managers about its specific setting and financial characteristics.

Alternatively, an MNC can use a decentralized management style, as illustrated in the bottom section of Exhibit 1.1. This style is more likely to result in higher agency costs because subsidiary managers may make decisions that fail to maximize the value of the entire MNC. Yet this management style gives more control to those managers who are closer to the subsidiary’s operations and environment. To the extent that subsidiary managers recognize the goal of maximizing the value of the overall MNC and are com- pensated in accordance with that goal, the decentralized management style may be more effective.

6 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 7

Exhibit 1.1 Management Styles of MNCs

Cash Management at Subsidiary A

Financial Managers of Parent

Financial Managers of Subsidiary A

Financial Managers of Subsidiary B

Cash Management at Subsidiary B

Cash Management at Subsidiary A

Cash Management at Subsidiary B

Inventory and Accounts Receivable

Management at Subsidiary A

Inventory and Accounts Receivable

Management at Subsidiary B

Financing at Subsidiary A

Financing at Subsidiary B

Capital Expenditures

at Subsidiary A

Capital Expenditures

at Subsidiary B

Financing at Subsidiary A

Financing at Subsidiary B

Capital Expenditures

at Subsidiary A

Capital Expenditures

at Subsidiary B

Centralized Multinational Financial Management

Decentralized Multinational Financial Management

Inventory and Accounts Receivable

Management at Subsidiary A

Inventory and Accounts Receivable

Management at Subsidiary B

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Given the clear trade-offs between centralized and decentralized management styles, some MNCs attempt to achieve the advantages of both. That is, they allow subsidiary managers to make the key decisions about their respective operations, but the parent’s management monitors those decisions to ensure they are in the MNC’s best interests.

1-2 Why MNCs Pursue International Business Multinational business has generally increased over time. Three commonly held theories to explain why MNCs are motivated to expand their business internationally are (1) the theory of comparative advantage, (2) the imperfect markets theory, and (3) the product cycle theory. These theories overlap to some extent and can complement one another in developing a rationale for the evolution of international business.

1-2a Theory of Comparative Advantage Specialization by countries can increase production efficiency. Some countries, such as Japan and the United States, have a technology advantage, whereas others, such as China and Malaysia, have an advantage in the cost of basic labor. Because these advantages cannot easily be transported, countries tend to use their advantages to specialize in the produc- tion of goods that can be produced with relative efficiency. This explains why countries such as Japan and the United States are large producers of electronic products, whereas countries such as Jamaica and Mexico are large producers of agricultural and handmade goods. Multinational corporations such as Oracle, Intel, and IBM have grown substantially in foreign countries because of their technology advantage.

A country that specializes in some products may not produce other products, so trade between countries is essential. This is the argument made by the classical theory of comparative advantage. Comparative advantages allow firms to penetrate foreign markets. Many of the Virgin Islands, for example, specialize in tourism and rely completely on inter- national trade for most products. Although these islands could produce some goods, it is more efficient for them to specialize in tourism. That is, the islands are better off using some revenues earned from tourism to import products than attempting to produce all the products they need.

1-2b Imperfect Markets Theory If each country’s markets were closed to all other countries, then there would be no international business. At the other extreme, if markets were perfect, such that the factors of production (such as labor) were easily transferable, then labor and other resources would flow wherever they were in demand. Such unrestricted mobility of factors would create equality in both costs and returns, thereby eliminating the comparative cost advantage, which is the rationale for international trade and investment. However, the real world suffers from imperfect market conditions where factors of production are somewhat immobile. Costs and often other restrictions affect the transfer of labor and other resources used for production. In addition, restrictions may be placed on transferring funds and other resources among countries. Because markets for the various resources used in production are “imperfect,” MNCs such as the Gap and Nike often capitalize on a foreign country’s particular resources by having many of their products manufactured in countries where labor costs are low. Imperfect markets provide an incentive for firms to seek out foreign opportunities.

8 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 9

Exhibit 1.2 International Product Life Cycle

Firm creates product to accommodate local

demand.

1

Firm differentiates product from competitors and/or expands product line in

foreign country.

4a

Firm’s foreign business declines as its competitive advantages are eliminated.

4b

Firm exports product to accommodate foreign

demand.

2

Firm establishes foreign subsidiary to establish

presence in foreign country and possibly

to reduce costs.

3

or

1-2c Product Cycle Theory One of the more popular explanations as to why firms evolve into MNCs is the product cycle theory. According to this theory, a firm first becomes established in its home market, where information about markets and competition is more readily available. To the extent that the firm’s product is perceived by foreign consumers to be superior to that available within their own countries, the firm may accommodate foreign consumers by exporting. As time passes, if the firm’s product becomes very popular in foreign countries, it may produce the product in foreign markets, thereby reducing its transportation costs. The firm may also develop strategies to prolong the foreign demand for its product. One frequently used approach is to differentiate the product so that competitors cannot duplicate it exactly.

These phases of the product cycle are illustrated in Exhibit 1.2. For instance, 3M Co. uses one new product to enter a foreign market, after which it expands the product line there. Whether the firm’s foreign business diminishes or expands over time will depend on how successful it is at maintaining some advantage over its competition.

Facebook initially established its business in the United States, but quickly recognized that its service was desired by consumers in other countries. Today, more than 85 percent of Facebook users are outside the United States, which has allowed Facebook’s advertising revenue from foreign countries to increase substantially over time.

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1-3 Methods to Conduct International Business Firms use several methods to conduct international business:

■■ International trade ■■ Licensing ■■ Franchising ■■ Joint ventures ■■ Acquisitions of existing operations ■■ Establishment of new foreign subsidiaries

In this section, each of these methods is discussed in turn, with particular attention paid to the respective risk and return characteristics.

1-3a International Trade International trade is a relatively conservative approach that can be used by firms to penetrate markets (by exporting) or to obtain supplies at a low cost (by importing). This approach entails minimal risk because the firm does not place any of its capital at risk. If the firm experiences a decline in its exporting or importing, it can usually reduce or discontinue that part of its business at a low cost.

Many large U.S.-based MNCs, including Boeing, DowDuPont, General Electric, and IBM, generate more than $4 billion in annual sales from exporting. Nonetheless, small businesses account for more than 20 percent of the value of all U.S. exports.

1-3b Licensing Licensing is an arrangement whereby one firm provides its technology (copyrights, patents, trademarks, or trade names) in exchange for fees or other considerations. Many producers of software allow foreign companies to use their software for a fee. In this way, they can generate revenue from foreign countries without establishing any production plants in foreign countries or transporting goods to foreign countries.

1-3c Franchising Under a franchising arrangement, one firm provides a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees, allowing local residents to own and manage the specific units. For example, McDonald’s, Pizza Hut, Subway, and Dairy Queen have franchises that are owned and managed by local residents in many foreign countries. As part of its franchising arrangements, McDonald’s typically purchases the land and establishes the building. It then leases the building to a franchisee and allows the franchisee to operate the business in the building for a specified number of years (such as 20 years), but the franchisee must follow standards set by McDonald’s when operating the business. Because franchising by an MNC often requires a direct investment in foreign operations, it is referred to as a direct foreign investment (DFI).

1-3d Joint Ventures A joint venture is a business that is jointly owned and operated by two or more firms. Many firms enter foreign markets by engaging in a joint venture with firms that are already established in those markets. Most joint ventures allow two firms to apply their

Web

www.trade.gov/mas/ian

Outlook of international

trade conditions

for each of several

industries.

10 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 11

respective comparative advantages in a given project. These ventures often require some degree of DFI, while the other parties involved in the joint ventures also participate in the investment.

For instance, General Mills joined in a venture with Nestlé SA so that the cereals produced by General Mills could be sold through the overseas sales distribution network established by Nestlé. Xerox Corp. and Fuji Co. (of Japan) engaged in a joint venture that allowed Xerox to penetrate the Japanese market while allowing Fuji to enter the photocopying business. Kellogg Co. and Wilmar International Ltd. (based in Singapore) have established a joint venture to manufacture and distribute cereals and snack products in China. Wilmar already has a wholly owned subsidiary in China, and that subsidiary is participating in the venture. Joint ventures between automobile manufacturers are numerous because each manufacturer can offer its own technological advantages. General Motors, for example, has ongoing joint ventures with automobile manufacturers in several different countries.

1-3e Acquisitions of Existing Operations Firms frequently acquire other firms in foreign countries as a means of penetrating foreign markets. Such acquisitions give firms full control over their foreign businesses and enable the MNC to quickly obtain a large portion of foreign market share. Acquisitions represent DFI because MNCs directly invest in a foreign country by purchasing the operations of target companies.

ExamplE Alphabet, the parent of Google, has made major international acquisitions to expand its business and improve its technology. It has acquired businesses in Australia (search engines), Brazil (search engines), Canada (mobile browser), China (search engines), Finland (micro-blogging), Germany (mobile software), Russia (online advertising), South Korea (weblog software), Spain (photo sharing), Sweden (videoconferencing), India (artificial intelligence), Belarus (computer vision), and the United Kingdom (graphics processing unit reliability). ●

Sometimes, however, the acquisition of an existing corporation may lead to large losses because of the large investment required. In addition, if the foreign operations perform poorly, it may be difficult to sell them to another company at a reasonable price.

Some firms engage in partial international acquisitions as a means of obtaining a toehold or stake in foreign operations. On the one hand, this approach requires a smaller investment than that needed for a full international acquisition, which limits the potential loss to the firm if the project fails On the other hand, the firm will not have complete control over foreign operations that are only partially acquired.

1-3f Establishment of New Foreign Subsidiaries Firms can also penetrate foreign markets by establishing new operations in foreign countries to produce and sell their products. Like a foreign acquisition, this method requires a large DFI. Establishing new subsidiaries may be preferred to foreign acquisi- tions because the operations can be tailored exactly to the firm’s needs. In addition, a smaller investment may be required than would be needed to purchase existing operations. However, the firm will not reap any rewards from the investment until the subsidiary is built and a customer base established.

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1-3g Summary of Methods The methods of increasing international business extend from the relatively simple approach of international trade to the more complex approach of acquiring foreign firms or establishing new subsidiaries. International trade and licensing are usually not viewed as examples of DFI because they do not involve direct investment in foreign operations. Franchising and joint ventures tend to require some investment in foreign operations but only to a limited degree. Foreign acquisitions and the establishment of new foreign sub- sidiaries require substantial investment in foreign operations and account for the largest portion of DFI.

Many MNCs use a combination of these methods to increase international business. For example, IBM and PepsiCo engage in substantial direct foreign investment, yet also derive some of their foreign revenue from various licensing agreements, which require less DFI to generate revenue.

ExamplE The evolution of Nike began in 1962 when Phil Knight, a student at Stanford’s business school, wrote a paper on how a U.S. firm could use Japanese technology to break the German dominance of the athletic shoe industry in the United States. After graduation, Knight visited the Unitsuka Tiger shoe company in Japan. He made a licensing agreement with that company to produce a shoe that he sold in the United States under the name Blue Ribbon Sports (BRS). In 1972, Knight exported his shoes to Canada. In 1974, he expanded his operations into Australia. In 1977, the firm licensed factories in Taiwan and Korea to produce athletic shoes and then sold the shoes in Asian countries. In 1978, BRS became Nike, Inc., and began to export shoes to Europe and South America. As a result of its exporting and its DFI, Nike’s international sales reached $1 billion by 1992 and now account for 55 percent of its revenue, amounting to more than $18 billion per year. ●

Exhibit 1.3 illustrates the effects of international business on an MNC’s cash f lows. In general, the cash outf lows associated with international business by the U.S. parent are used to pay for imports, to comply with its international arrangements, and/or to support the creation or expansion of foreign subsidiaries. At the same time, an MNC receives cash f lows in the form of payment for its exports, fees for the services it provides within interna- tional arrangements, and remitted funds from the foreign subsidiaries. The first diagram in this exhibit illustrates the case in which an MNC engages in international trade; its international cash f lows result either from paying for imported supplies or from receiving payment in exchange for products that it exports.

The second diagram illustrates the case in which an MNC engages in some interna- tional arrangements, such as international licensing, franchising, or joint ventures. Any such arrangement may require the MNC to have cash outf lows in foreign countries to cover, for example, the expenses associated with transferring technology or funding par- tial investment in a franchise or joint venture. These arrangements generate cash f lows for the MNC in the form of fees for services (for example, technology, support assistance) that it provides.

The third diagram in Exhibit 1.3 illustrates the case of an MNC that engages in direct foreign investment. This type of MNC has one or more foreign subsidiaries. Cash out- f lows from the U.S. parent to its foreign subsidiaries may take the form of invested funds to help finance the operations of the foreign subsidiaries. In addition, cash f lows from the foreign subsidiaries to the U.S. parent occur in the form of remitted earnings and fees for services provided by the parent; all of these f lows can be classified as remitted funds from the foreign subsidiaries.

12 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 13

Exhibit 1.3 Cash Flow Diagrams for MNCs

Foreign Firms or Government

Agencies

MNC

MNC

International Trade by the MNC

Licensing, Franchising, Joint Ventures by the MNC

Investment in Foreign Subsidiaries by the MNC

Foreign Importers

Foreign Exporters

Cash Inflows from Exporting

Cash Outflows to Pay for Importing

Cash Inflows from Services Provided

Cash Outflows for Services Received

Foreign Subsidiaries

MNC

Cash Inflows from Remitted Earnings

Cash Outflows to Finance the Operations

1-4 Valuation Model for an MNC The value of an MNC is relevant to its shareholders and its debt holders. When managers make decisions that maximize the firm’s value, they also maximize shareholder wealth. Given that international financial management should be conducted with the goal of increasing the MNC’s value, it is useful to review some basics of valuation and identify the key factors that affect an MNC’s value over time.

1-4a Domestic Valuation Model Before modeling an MNC’s value, consider the valuation of a purely domestic firm in the United States that does not engage in any foreign transactions. The value ( )V of the purely domestic firm is commonly specified as the present value of its expected dollar cash f lows:

∑ ( )

( )   



  



CF

1 $,

1

5 15

V E

k t

t t

n

where (CF )$ ,E t denotes expected cash f lows to be received at the end of period t; n is the number of future periods in which cash f lows are received; and k represents not only

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the weighted average cost of capital, but also the required rate of return by investors and creditors that provide funds to the MNC.

Dollar Cash Flows The dollar cash f lows in period t comprise funds received by the firm minus funds needed to pay expenses or taxes or to reinvest in the firm (such as an investment to replace old computers or machinery). The expected cash f lows are estimated from knowledge about existing projects as well as other projects that will be implemented in the future. A firm’s decisions about how it should invest funds to expand its business can affect its expected future cash f lows, which in turn can affect the firm’s value. Holding other factors constant, an increase in expected cash f lows over time should increase the value of a firm.

Cost of Capital The required rate of return ( )k in the denominator of the valuation equation represents the cost of capital (including both the cost of debt and the cost of equity) to the firm and is, in essence, a weighted average of the cost of capital based on all of the firm’s projects. In making decisions that affect its cost of debt or equity for one or more projects, the firm also inf luences the weighted average of its cost of capital and, therefore, the required rate of return. If the firm’s credit rating is suddenly lowered, for example, then its cost of capital will probably increase, and so will its required rate of return. Holding other factors constant, an increase in the firm’s required rate of return will reduce the value of the firm because expected cash f lows must be discounted at a higher interest rate. Conversely, a decrease in the firm’s required rate of return will increase the value of the firm because expected cash f lows will be discounted at a lower required rate of return.

1-4b Multinational Valuation Model An MNC’s value can be specified in the same manner as a purely domestic firm’s value. Managers must consider a new factor, however: The expected cash f lows generated by a U.S.-based MNC’s parent in period t may be coming from various countries and may be denominated in different foreign currencies.

In this case, the foreign currency cash f lows will be converted into dollars. The expected dollar cash f lows to be received at the end of period t are then equal to the sum of the products of cash f lows denominated in each currency j multiplied by the expected exchange rate at which currency j could be converted into dollar cash f lows by the MNC at the end of period t:

∑ ( ) ( )( )  CF CF$, , , 1

5 3 5

E E E S t j t j t

j

m

where CF ,j t represents the amount of cash f low denominated in a particular foreign currency j at the end of period t, and ,S j t denotes 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.

Dollar Cash Flows of an MNC That Uses Two Currencies An MNC that does business in two currencies could measure its expected dollar cash f lows in any period by multiplying the expected cash f low in each currency by the expected exchange rate at which that currency could be converted to dollars and then summing those two products.

Consider an MNC’s business transactions as a portfolio of currency cash f lows, with one set of cash f lows for each currency in which it conducts business. The expected dollar cash f lows derived from each of those currencies can be combined to determine the total

14 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 15

expected dollar cash f lows in the given period. It is easier to derive an expected dollar cash f low value for each currency before combining the cash f lows among currencies within a given period, because each currency’s cash f low amount must be converted to a common unit (the dollar) before combining the amounts.

ExamplE Carolina Co. expects cash flows of $100,000 from its local business and 1 million Mexican pesos from its busi- ness in Mexico at the end of period t. Assuming that the peso’s value is expected to be $.09 when converted into dollars, the expected dollar cash flows are:

CF CF

$ CF from U.S. operations $ CF from operations in mexico

$100, 000 1,000,000 pesos $.09

$100,000 $90,000 $190,000

$, , , 1

∑ ( ) ( )( )

( )

 

 

 

E E E S t j t j t

j

m

5 3

5 1

5 1 3

5 1

5

5

The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars, so they did not need to be converted. ●

Dollar Cash Flows of an MNC That Uses Multiple Currencies The same process just described can be employed to estimate the dollar cash f lows an MNC that does business in many foreign currencies. The general formula for estimating the dollar cash f lows to be received by an MNC from multiple currencies in one period can be written as follows:

∑ ( ) ( )( )  E E E St j t j t j

m

CF CF $, , ,

1

5 3 5

ExamplE Assume that Yale Co. will receive cash in 15 different countries at the end of the next period. To estimate the value of Yale Co., the first step is to estimate the amount of cash flows that it will receive at the end of the period in each currency (such as 2 million euros, 8 million Mexican pesos, and so on). Second, obtain a forecast of the currency’s exchange rate for cash flows that will arrive at the end of the period for each of the

15 currencies (such as 5euro forecast $1.40, 5peso forecast $.12, and so on). The existing exchange rate can be used as a forecast for the future exchange rate, although many alternative methods are also possible (as explained in Chapter 9). Third, multiply the amount of each foreign currency to be received by the forecasted exchange rate of that currency to estimate the dollar cash flows to be received due to each currency. Fourth, add the estimated dollar cash flows for all 15 currencies to determine the total expected dollar cash flows in the period. The previous equation captures the four steps just described. When applying that equation to this example, m 5 15 because there are 15 different currencies. ●

Valuation of an MNC’s Cash Flows over Multiple Periods The process of estimating dollar cash f lows for a single period can be adapted to account for multiple periods. First, apply the same process described for a single period to all future periods in which the MNC will receive cash f lows; this will generate an estimate of total dollar cash f lows to be received in every period in the future. Second, discount the estimated total dollar cash f low for each period at the weighted cost of capital ( )k . Third, add these discounted cash f lows to estimate the value of this MNC.

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The process for valuing an MNC receiving multiple currencies over multiple periods can be expressed formally as follows:

∑ ∑

( ) ( ) ( )

 

 

 

  

 

  

CF

1

, , 1

1

5

3

1

5

5

V E E S

k

j t j t j

m

t t

n

where CF ,j t is the cash f low denominated in a particular currency (which may be dollars) and ,S j t denotes the exchange rate at which the MNC can convert the foreign currency to the domestic currency at the end of period t. Whereas the previous equation is applied to single-period cash f lows, this equation considers cash f lows over multiple periods and then discounts those f lows to obtain a present value.

Because the management of an MNC should focus on maximizing its value, the equation for valuing an MNC is extremely important. According to this equation, the value ( )V will increase in response to managerial decisions that increase the amount of its cash f lows in a particular currency (CF )j or to conditions that increase the exchange rate at which that currency is converted into dollars ( )S j .

To avoid double counting, cash f lows of the MNC’s subsidiaries are considered in the valuation model only when they ref lect transactions with the U.S. parent. Therefore, any expected cash f lows received by foreign subsidiaries should not be counted in the valuation equation until they are remitted to the parent.

The denominator of the valuation model for the MNC remains unchanged from the original valuation model for the purely domestic firm. However, note that the weighted average cost of capital for the MNC is based on funding some projects involving business in different countries. In consequence, any decision by the MNC’s parent that affects the cost of its capital for supporting projects in a specific country will also affect its weighted average cost of capital (and required rate of return) and, therefore, its value.

ExamplE Austin Co. is a U.S.-based MNC that sells video games to U.S. consumers; it also has European subsidiaries that produce and sell the games in Europe. Last year, Austin received $40 million in cash flows from its U.S. operations and 20 million euros from its European operations. The euro was valued at $1.30 when the European cash flows were converted to dollars and remitted to the U.S parent, so Austin’s cash flows last year are calculated as follows:

austin’s total $ cash flows last year $ cash flows from U.S. operations $ cash flows from foreign operations

$ cash flows from U.S. operations [(euro cash flows) (euro exchange rate)]

$40,000,000 [(20,000,000 euros) ($1.30)] $40,000,000 $ 26,000,000 $66,000,000

5 1

5 1 3

5 1 3

5 1

5

Assume that Austin Co. plans to maintain its business operations in the same way in the United States and Europe for the next three years. As a basic valuation model, the firm could use last year’s cash flows to estimate each future year’s cash flows; then its expected cash flows would be $66 million for each of the next three years. Its valuation could be estimated by discounting these cash flows at its cost of capital. ●

16 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 17

1-4c Uncertainty Surrounding an MNC’s Cash Flows The MNC’s future cash f lows (and therefore its valuation) are subject to uncertainty because of its exposure not only to domestic economic conditions but also to interna- tional economic conditions, political conditions, and exchange rate risk. These factors are explained next, and Exhibit 1.4 complements the discussion.

Exposure to International Economic Conditions To the extent that a foreign country’s economic conditions affect an MNC’s cash f lows, they also affect the MNC’s valuation. The cash inf lows that an MNC receives from sales in a foreign country during a given period depend on the demand by that country’s consumers for the MNC’s products, which in turn is affected by that country’s national income in that period. If economic con- ditions improve in that country, consumers there may enjoy an increase in their income and the employment rate may rise. In that case, those consumers will have more money to spend, and their demand for the MNC’s products will increase.

Conversely, an MNC can be adversely affected by its exposure to declining interna- tional economic conditions. If conditions weaken in the foreign country where the MNC does business, that country’s consumers may suffer a decrease in their income and the employment rate may decline. Those consumers will then have less money to spend, and their demand for the MNC’s products will decrease. In this case, the MNC’s cash f lows are reduced because of its exposure to the harsher international economic conditions.

International economic conditions can also affect the MNC’s cash f lows indirectly by affecting its home economy. When a country’s economy strengthens and, in turn, its con- sumers buy more products from other countries, the firms in those other countries will experience stronger sales and cash f lows. Conversely, if the foreign country’s economy weakens and its consumers buy fewer products from other countries, then the firms in those countries will experience weaker sales and cash f lows.

Exhibit 1.4 How an MNC’s Valuation Is Exposed to Uncertainty (Risk)

V 5 S n

t51

S [E (CFj,t ) 3 E (Sj,t )] m

j51

(1 1 k )t

Uncertain foreign currency cash flows due to uncertain foreign economic

and political conditions Uncertainty surrounding future exchange rates

Uncertainty Surrounding an MNC’s Valuation:

Exposure to Foreign Economies: If [CFj,t , E (CFj,t )] V

Exposure to Political Risk: If [CFj,t , E (CFj,t )] V

Exposure to Exchange Rate Risk: If [Sj,t , E (Sj,t )] V

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ExamplE Recall from the previous example that Austin Co. expects annual cash flows of $40 million from its U.S. opera- tions. If Europe experiences a recession, however, Austin expects European demand for many U.S. products to be reduced, which will adversely affect the U.S. economy. Under these conditions, the U.S. demand for Austin’s video games would decline, reducing its expected annual cash flows from its U.S. operations from $40 million to $38 million. A European recession would naturally result in reduced European demand for Austin’s video games, so the company also reduces its expected euro cash flows from its European operations from 20 million euros to 16 million euros. ●

The effects on international economic conditions are illustrated in Exhibit 1.5, which shows the different ways in which weak European conditions can affect the valuations of U.S.-based MNCs. The string of effects (from left to right) in this exhibit indicates how weak European economic conditions cause a decline in the demand for the products made by U.S. firms. The result is weaker cash f lows of the U.S.-based MNCs that sell products either as exports or through their European subsidiaries to European customers. In addi- tion, the weak European economy can weaken the U.S. economy, resulting in a lower U.S. demand for products produced by U.S.-based MNCs and domestic U.S. firms.

Exhibit 1.5 Potential Effects of International Economic Conditions

Reduced Sales and

Cash Flows of U.S. Firms

Reduced Valuations

of U.S. Firms

Weak U.S.

Economy

Weak European Economy

Reduced European

Demand for Products at European

Subsidiaries of U.S. Firms

Reduced European Demand for U.S. Firms’

Exports

Exposure to International Political Risk Political risk in any country can affect the level of an MNC’s sales. A foreign government may increase taxes or impose barriers on the MNC’s subsidiary. Alternatively, consumers in a foreign country may boycott the MNC if friction arises between the government of their country and the MNC’s home country. These kinds of political actions can, in turn, reduce the cash f lows of an MNC. The term “country risk” is commonly used to ref lect an MNC’s exposure to a variety of country conditions, including political actions such as friction within the government, government policies (such as tax rules), and financial conditions within that country.

18 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 19

ExamplE From time to time, the United States imposes sanctions on Russia for political reasons, and in retaliation Russia bans various food items that were previously imported from the United States. The ban by Russia reduces the sales and cash flows of some U.S.-based MNCs that had previously exported to Russia. Those MNCs have nothing to do with the sanctions imposed on Russia, yet they can be adversely affected by the political friction between the United States and Russia. ●

ExamplE As described in the previous example, Austin Co. now anticipates a European recession and so has revised its expected annual cash flows from its European operations to be 16 million euros. The dollar cash flows that Austin will receive from these euro cash flows depend on the exchange rate at the time that those euros are converted to dollars. If the exchange rate is expected to be $1.30 , then Austin will have the following cash flows:

austin’s $ cash flows resulting from European operations austin’s cash flows in euros euro exchange rate

16,000,000 euros $1.30 $20,800,000

5 3

5 3 5

If Austin believes that the anticipated European recession will cause the euro’s value to weaken and be worth only $1.20 when the euros are converted into dollars, then its estimate of the dollar cash flows from European operations would be revised as follows:

austin’s $ cash flows resulting from European operations austin’s cash flows in euros euro exchange rate

16,000,000 euros $1.20 $19,200,000

5 3

5 3 5

Thus, Austin’s expected dollar cash flows are reduced as a result of the decrease in the expected value of the euro at the time of conversion into dollars. ●

Exposure to Exchange Rate Risk If the foreign currencies to be received by a U.S.-based MNC suddenly weaken against the dollar, then the MNC will receive a lower amount of dollar cash f lows than expected. Therefore, the MNC’s cash f lows will be reduced.

This conceptual framework can be used to understand how MNCs such as Facebook and Alphabet (Google) are affected by exchange rate movements. Alphabet now receives more than half of its total revenue from outside the United States, from markets where it provides advertising for non-U.S. companies targeted at non-U.S. users. Consequently, its dollar cash f lows are favorably affected when the currencies it receives appreciate against the dollar over time.

As Facebook’s international business continues to grow, its estimated dollar cash f lows in any period will become more sensitive to the exchange rates of the currencies in which its foreign currency cash f lows are denominated. If the revenue it receives is denominated in currencies that appreciate against the dollar over time, then its dollar cash f lows and valu- ation will increase. Conversely, if the revenue it receives is denominated in currencies that depreciate against the dollar over time, its dollar cash f lows and valuation will decrease.

Many MNCs have cash outf lows in one or more foreign currencies because they import supplies or materials from companies in other countries. When an MNC anticipates future cash outf lows in foreign currencies, it is exposed to exchange rate movements, but in the opposite direction. That is, if those foreign currencies strengthen, then the MNC will need more dollars to obtain the foreign currencies to make its payments.

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ExamplE Because Austin Co. does substantial business in Europe, its value is strongly influenced by how much revenue it expects to earn from that business. As a result of some events that occurred in Europe today, economic conditions in Europe are subject to considerable uncertainty. Although Austin does not change its forecasts of expected cash flows, it is concerned that the actual flows could deviate substantially from those forecasts. The increased uncertainty surrounding these cash flows will increase the firm’s cost of capital, because its investors will now require a higher rate of return. In other words, although the numerator (estimated cash flows) of the valuation equation has not changed, the denominator has increased due to the increased uncertainty surrounding the cash flows. As a consequence, the valuation of Austin Co. decreases. ●

1-4d How Uncertainty Affects the MNC’s Cost of Capital If there is suddenly more uncertainty about an MNC’s future cash f lows, then investors would require a higher expected rate of return, which increases the MNC’s cost of obtain- ing capital and lowers its valuation.

If the uncertainty surrounding economic conditions that inf luence cash f lows declines, the uncertainty surrounding cash f lows of MNCs also declines and results in a lower required rate of return and cost of capital for MNCs. Consequently, the valuations of MNCs increase.

1-5 Organization of the Text The chapters in this textbook are organized as shown in Exhibit 1.6. Chapters 2 through 8 discuss international markets and conditions from a macroeconomic perspective, focus- ing on external forces that can affect the value of an MNC. Although financial managers

Exhibit 1.6 Organization of Chapters

Background on International

Financial Markets (Chapters 2–5)

Long-Term Investment and

Financing Decisions (Chapters 13–18)

Short-Term Investment and

Financing Decisions (Chapters 19–21)

Risk and Return of MNC

Exchange Rate Behavior

(Chapters 6–8)

Exchange Rate Risk Management (Chapters 9–12)

Value and Stock Price of MNC

20 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 21

cannot control such forces, they can control the extent of their firm’s exposure to them. These chapters focus on macroeconomic concepts that serve as a foundation for interna- tional financial management.

Chapters 9 through 21 take a microeconomic perspective and focus on how the financial management of an MNC can affect its value. Financial decisions by MNCs are commonly classified as either investing decisions or financing decisions. In general, investing deci- sions by an MNC tend to affect the numerator of the valuation model because such deci- sions affect expected cash f lows. In addition, investing decisions by the MNC that alter the firm’s weighted average cost of capital may affect the denominator of the valuation model. Long-term financing decisions by an MNC tend to affect the denominator of the valuation model because they affect its cost of capital.

■■ The main goal of an MNC is to maximize share- holder wealth. When managers are tempted to serve their own interests instead of those of shareholders, an agency problem exists. Multinational corporations tend to experience greater agency problems than do domestic firms because managers of foreign subsid- iaries might be tempted to make decisions that serve their subsidiaries instead of the overall MNC. Proper incentives and consistent communication from the parent may help to ensure that subsidiary managers focus on serving the overall MNC.

■■ International business is encouraged by three key theories. The theory of comparative advantage sug- gests that each country should use its comparative advantage to specialize in its area of production and rely on other countries to meet other needs. The imperfect markets theory suggests that imperfect markets render the factors of production immobile, which encourages countries to specialize based on the resources they have. The product cycle theory suggests that, after firms are established in their

summary home countries, they commonly expand their product specialization in foreign countries.

■■ The most common methods by which firms conduct international business are international trade, licens- ing, 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 the forma- tion of foreign subsidiaries require substantial capital investments but offer the potential for large returns.

■■ The valuation model of an MNC shows that the MNC’s value is favorably affected when its expected foreign cash inf lows increase, the currencies denominating those cash inf lows increase, or the MNC’s required rate of return decreases. Conversely, the MNC’s value is adversely affected when its expected foreign cash inf lows decrease, the values of currencies denomi- nating those cash f lows decrease (assuming that the MNC has net cash inf lows in foreign currencies), or the MNC’s required rate of return increases.

Point Yes. When a U.S.-based MNC competes in some countries, it may encounter some business norms there that are not allowed in the United States. For example, when competing for a govern- ment contract, firms might provide payoffs to the government officials who will make the decision. Yet in the United States, a firm will sometimes take a client on an expensive golf outing or provide

point/Counterpoint should an MNC reduce its ethical standards to Compete internationally?

skybox tickets to sporting events; this practice is no different than making a payoff. If the payoffs are bigger in some foreign countries, the MNC can compete only by matching the payoffs provided by its competitors. Counterpoint No. A U.S.-based MNC should maintain a standard code of ethics that applies to any country, even if it is at a disadvantage in a foreign

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country that allows activities that might be viewed as unethical. In this way, the MNC establishes more credibility worldwide.

Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Answers are provided in Appendix A at the back of the text.

1. What are typical reasons why MNCs expand internationally?

self-test 2. Explain why unfavorable economic or political conditions affect the MNC’s cash f lows, required rate of return, and valuation.

3. Identify the more obvious risks faced by MNCs that expand internationally.

1. Agency Problems of MNCs

a. Explain the agency problem of MNCs. b. Why might agency costs be larger for an MNC than for a purely domestic firm? 2. Comparative Advantage

a. Explain how the theory of comparative advantage relates to the need for international business. b. Explain how the product cycle theory relates to the growth of an MNC. 3. Imperfect Markets

a. Explain how the existence of imperfect markets has led to the establishment of subsidiaries in foreign markets. b. If perfect markets existed, would wages, prices, and interest rates among countries be more similar or less similar than under conditions of imperfect markets? Why? 4. International Opportunities

a. Do you think the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which alternative is likely to have more risk? b. Describe a scenario in which the size of a corporation is not affected by access to international opportunities. c. Explain why MNCs such as Coca-Cola and PepsiCo still have numerous opportunities for international expansion. 5. International Opportunities Due to the Internet

a. What factors cause some firms to become more internationalized than others?

Questions and applications b. Why might the Internet have resulted in more international business? 6. Impact of Exchange Rate Movements Plak Co. of Chicago has several European subsidiaries that remit earnings to it each year. Explain how appreciation of the euro (the currency used in many European countries) would affect Plak’s valuation. 7. Benefits and Risks of International Business As an overall review of this chapter, identify possible reasons for growth in international business. Then list the various disadvantages that may discourage international business. 8. Valuation of an MNC Hudson Co., a U.S. firm, has a subsidiary in Mexico, where political risk has recently increased. Hudson’s best guess of its future peso cash f lows to be received has not changed. However, its valuation has declined as a result of the increase in political risk. Explain. 9. Centralization and Agency Costs Would the agency problem be more pronounced for Berkeley Corp., whose parent company makes most major decisions for its foreign subsidiaries, or Oakland Corp., which uses a decentralized approach? 10. Global Competition Explain why more- standardized product specifications across countries can increase global competition. 11. Exposure to Exchange Rates McCanna Corp., a U.S. firm, has a French subsidiary that produces and exports wine. All of the European countries where it sells its wine use the euro as their currency, which is the same currency used in France. Is McCanna Corp. exposed to exchange rate risk?

22 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 23

12. Macro versus Micro Topics Review this book’s table of contents and indicate whether each of the chapters from Chapter 2 through Chapter 21 has a macro or micro perspective. 13. Methods Used to Conduct International Business Duve, Inc., desires to penetrate a foreign market either by creating a licensing agreement with a foreign firm or by acquiring a foreign firm. Explain the differences in potential risk and return between a licensing agreement with a foreign firm and the acquisition of a foreign firm. 14. International Business Methods Snyder Golf Co., a U.S. firm that sells high-quality golf clubs in the United States, wants to expand internationally by selling the same golf clubs in Brazil. a. Describe the trade-offs that are involved for each method (such as exporting, direct foreign investment, and so on) that Snyder could use to achieve its goal. b. Which method would you recommend for this firm? Justify your recommendation. 15. Impact of Political Risk Explain why political risk may discourage international business. 16. Impact of 9/11 Following the terrorist attacks on the United States on September 11, 2001, the valuations of many MNCs declined by more than 10 percent. Explain why the expected cash f lows of MNCs were reduced, even if they were not directly hit by the terrorist attacks.

advanced Questions 17. International Joint Venture Anheuser-Busch (which is now part of AB InBev due to a merger), the producer of Budweiser and other beers, has engaged in a joint venture with Kirin Brewery, the largest brewery in Japan. The joint venture enabled Anheuser-Busch to have its beer distributed through Kirin’s distribution channels in Japan. In addition, it could utilize Kirin’s facilities to produce beer that would be sold locally. In return, Anheuser-Busch provided information about the American beer market to Kirin. a. Explain how the joint venture enabled Anheuser- Busch to achieve its objective of maximizing shareholder wealth. b. Explain how the joint venture limited the risk of the international business.

c. Many international joint ventures are intended to circumvent barriers that might otherwise prevent

foreign competition. What barrier in Japan did Anheuser-Busch circumvent as a result of the joint venture? What barrier in the United States did Kirin circumvent as a result of the joint venture? d. Explain how Anheuser-Busch could have lost some of its market share in countries outside Japan as a result of this particular joint venture.

18. Impact of Eastern European Growth The managers of Loyola Corp. recently had a meeting to discuss new opportunities in Europe as a result of recent integration among Eastern European countries. They decided not to penetrate new markets because of their present focus on expanding market share in the United States. Loyola’s financial managers have deve- loped forecasts for earnings based on the 12  percent market share (defined here as its percentage of total European sales) that Loyola currently has in Eastern Europe. Is 12 percent an appropriate estimate for next year’s Eastern European market share? If not, does it likely overestimate or underestimate the actual Eastern European market share next year?

19. Valuation of an MNC Birm Co., based in Alabama, is considering several international opportunities in Europe that could affect the firm’s value. Its valuation depends on four factors: (1) expected cash f lows in dollars, (2) expected cash f lows in euros that are ultimately converted into dollars, (3) the rate at which it can convert euros to dollars, and (4) Birm’s weighted average cost of capital. For each of the following opportunities, identify which factors will be affected.

a. Birm plans a licensing deal in which it will sell technology to a firm in Germany for $3 million; the payment is invoiced in dollars, and this project has the same risk level as its existing businesses. b. Birm plans to acquire a large firm in Portugal that is riskier than its existing businesses. c. Birm plans to discontinue its relationship with a U.S. supplier so that it can import a small amount of supplies (denominated in euros) at a lower cost from a Belgian supplier. d. Birm plans to export a small amount of materials to Ireland that are denominated in euros.

20. Assessing Motives for International Business Fort Worth, Inc., specializes in manufacturing some basic parts for sports utility vehicles (SUVs) that are produced and sold in the United States. Its main advantage in the United

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States is that its production is efficient and less costly than that of some other unionized manufacturers. It has a substantial market share in the United States. Its manufacturing process is labor intensive. The company pays relatively low wages compared to its U.S. competitors, but has guaranteed the local workers that their positions will not be eliminated for the next 30 years. It hired a consultant to determine whether it should set up a subsidiary in Mexico, where the parts would be produced. The consultant suggested that Fort Worth should expand for the following reasons. Offer your opinion on whether the consultant’s reasons are logical.

a. Theory of competitive advantage: Not many SUVs are sold in Mexico, so Fort Worth would not have to face much competition there.

b. Imperfect markets theory: Fort Worth cannot easily transfer workers to Mexico, but it can establish a subsidiary there that it can use to penetrate a new market.

c. Product cycle theory: Fort Worth has been successful in the United States. It has limited growth opportunities because it already controls much of the U.S. market for the parts it produces. The natural next step is to conduct the same business in a foreign country.

d. Exchange rate risk: The exchange rate of the peso has weakened recently, which would allow Fort Worth to build a plant in Mexico at a very low cost (by exchanging dollars for the cheap pesos to build the plant).

e. Political risk: The political conditions in Mexico have stabilized in the last few months, so Fort Worth should attempt to penetrate the Mexican market now.

21. Valuation of Walmart’s International Business In addition to its stores in the United States, Walmart Stores, Inc., has numerous retail units in Argentina, Brazil, Canada, China, Mexico, and the United Kingdom. Consider that the value of Walmart is composed of two parts: a U.S. part (due to business in the United States) and a non-U.S. part (due to business in other countries). Explain how to determine the present value (in dollars) of the non-U.S. part assuming that you had access to all the details of Walmart businesses outside the United States.

22. Impact of International Business on Cash Flows and Risk Nantucket Travel Agency specializes in tours for American tourists. Until recently, all of its business was in the United States.

It just established a subsidiary in Athens, Greece, which provides tour services in the Greek islands for American visitors. This subsidiary rented a shop near the port of Athens. It also hired residents of Athens who could speak English and provide tours of the Greek islands. The subsidiary’s main costs are rent and salaries for its employees and the lease of a few large boats in Athens that it uses for tours. American tourists pay for the entire tour in dollars at Nantucket’s main U.S. office before they depart for Greece.

a. Explain why Nantucket may be able to effectively capitalize on international opportunities such as the Greek island tours.

b. Nantucket is privately owned by owners who reside in the United States and work in the main office. Explain possible agency problems associated with the creation of a subsidiary in Athens, Greece. How can Nantucket attempt to reduce these agency costs?

c. Greece’s cost of labor and rent are relatively low. Explain why this information is relevant to Nantucket’s decision to establish a tour business in Greece.

d. Explain how the cash f low situation of the Greek tour business exposes Nantucket to exchange rate risk. Is Nantucket favorably or unfavorably affected when the euro (Greece’s currency) appreciates against the dollar? Explain.

e. Nantucket plans to finance its Greek tour busi- ness. Its subsidiary could obtain loans in euros from a bank in Greece to cover its rent, and its main office could pay off the loans over time. Alternatively, its main office could borrow dollars and then periodi- cally convert dollars to euros to pay the expenses in Greece. Does either type of loan reduce the exposure of Nantucket to exchange rate risk? Explain.

f. Explain how the Greek island tour business could expose Nantucket to political country risk.

23. Valuation of an MNC Rose Co., a U.S. firm, has expanded its business by establishing networking portals in numerous countries, including Argentina, Australia, China, Germany, Ireland, Japan, and the United Kingdom. It has cash outf lows associated with the creation and administration of each portal. It also generates cash inf lows from selling advertising space on its website. Each portal results in cash f lows in a different currency. Thus, the valuation of Rose is based

24 part 1: The International Financial Environment

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Chapter 1: Multinational Financial Management: An Overview 25

on its expected future net cash f lows in Argentine pesos after converting them into U.S. dollars, its expected net cash f lows in Australian dollars after converting them into U.S. dollars, and so on. Explain how and why Rose’s valuation would change if most investors suddenly expected that the dollar would weaken against most currencies over time.

24. Uncertainty Surrounding an MNC’s Valuation Carlisle Co. is a U.S. firm that is about to purchase a large company in Switzerland at a purchase price of $20 million. This company, which produces furniture and sells it locally (in Switzerland), is expected to earn large profits every year. Following its acquisition, the company will become a subsidiary of Carlisle and will periodically remit its excess cash f lows due to its profits to Carlisle Co. Assume that Carlisle Co. has no other international business. Carlisle has $10 million that it will use to pay for part of the Swiss company and will finance the rest of its purchase with borrowed dollars. Carlisle Co. can obtain supplies from either a U.S. supplier or a Swiss supplier (in which case the payment would be made in Swiss francs). Both suppliers are very reputable and there would be no exposure to country risk when using either supplier. Is the valuation of the total cash f lows of Carlisle Co. more uncertain if it obtains its supplies from a U.S. firm or from a Swiss firm? Explain brief ly.

25. Impact of Exchange Rates on MNC Value Olmsted Co. has small computer chips assembled in Poland and transports the final assembled products to the parent company; the parent then sells these products in the United States. The assembled products are invoiced in dollars. Olmsted Co. uses Polish currency (the zloty) to produce these chips and assemble them in Poland. The Polish subsidiary pays the employees in the local currency (zloty), and Olmsted Co. finances its subsidiary operations with loans from a Polish bank (in zloty). The parent of Olmsted sends sufficient monthly payments (in dollars) to the subsidiary to repay the loan and other expenses incurred by the subsidiary. If the Polish zloty depreciates against the dollar over time, will that have a favorable, unfavorable, or neutral effect on the value of Olmsted Co.? Brief ly explain.

26. Impact of Uncertainty on MNC Value Minneapolis Co. is a major exporter of products to Canada. Today, an event occurred that has increased

the uncertainty surrounding the Canadian dollar’s future value over the long term. Explain how this event might affect the valuation of Minneapolis Co. 27. Exposure of MNCs to Exchange Rate Movements Arlington Co. expects to receive 10  million euros in each of the next 10 years. It will need to obtain 2 million Mexican pesos in each of the next 10 years. The euro exchange rate is pres- ently valued at $1.38 and is expected to depreciate by 2  percent each year over time. The peso is valued at $.13 and is expected to depreciate by 2 percent each year over time. Review the valuation equation for an MNC. Do you think that the exchange rate movements will have a favorable or unfavorable effect on the MNC? 28. Impact of a Recession on an MNC’s Value If a U.S. recession occurred without any change in interest rates, identify the part of the MNC valuation equation that would most likely be affected. 29. Exposure of MNCs to Exchange Rate Movements Because of the low labor costs in Thailand, Melnick Co. (based in the United States) recently established a major research and development subsidiary there that it owns. The subsidiary was created to improve new products that Melnick can sell in the United States (denominated in dollars) to U.S. customers. The subsidiary pays its local employees in baht (the Thai currency). The subsidiary has a small amount of sales denominated in baht, but its expenses are much larger than its revenue. Melnick has just obtained a large loan denominated in baht that will be used to expand its subsidiary. The business that the parent company conducts in the United States is not exposed to exchange rate risk. If the Thai baht weakens over the next 3 years, will the value of Melnick Co. be favorably affected, unfavorably affected, or not affected? Brief ly explain. 30. Shareholder Rights of Investors in MNCs MNCs tend to expand more when they can more easily access funds by issuing stock. In some countries, shareholder rights are very limited, and the MNCs have limited ability to raise funds by issuing stock. Explain why access to funding is more restricted for MNCs based in countries where shareholder rights are limited. 31. MNC Cash Flows and Exchange Rate Risk Tuscaloosa Co. is a U.S. firm that assembles phones in Argentina and transports the final assembled products to the parent, which then sells

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the products in the United States. The assembled products are invoiced in dollars. The Argentine subsidiary obtains some material from China, and the Chinese exporter is willing to accept Argentine pesos as payment for these materials that it exports. The Argentine subsidiary pays its employees in the local currency (pesos), and finances its operations with loans from an Argentine bank (in pesos). Tuscaloosa Co. has no other international business. If the Argentine peso depreciates against the dollar over time, will that have a favorable, unfavorable, or neutral effect on Tuscaloosa Co.? Brief ly explain.

32. MNC Cash Flows and Exchange Rate Risk Asheville Co. has a subsidiary in Mexico that develops software for its parent. It rents a large facility in Mexico and hires many people in Mexico to work in this facility. Asheville Co. has no other international business. All operations are presently funded by the parent company. All the software is sold to U.S. firms by the parent company and invoiced in U.S. dollars.

a. If the Mexican peso appreciates against the dollar, will this have a favorable effect, unfavorable effect, or no effect on Asheville’s value?

b. Asheville Co. plans to borrow funds to support its expansion in the United States. The Mexican interest rates are presently lower than U.S. interest rates, so Asheville obtains a loan denominated in Mexican pesos to support its expansion in the United States. Will the borrowing of pesos increase, decrease, or have no effect on its exposure to exchange rate risk? Briefly explain.

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