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Direct Exchange Rates over Time

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International Financial Management

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Australia • Brazil • Mexico • Singapore • United Kingdom • United States

International Financial tnemeganaM

13th Edition

Jeff Madura Florida Atlantic University

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International Financial Management, 13th Edition Jeff Madura

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Dedicated to my mother Irene

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Brief Contents

PART 1: The International Financial Environment 1 1 Multinational Financial Management: An Overview 3 2 International Flow of Funds 33 3 International Financial Markets 63 4 Exchange Rate Determination 103 5 Currency Derivatives 131

PART 2: Exchange Rate Behavior 185 6 Government Influence on Exchange Rates 187 7 International Arbitrage and Interest Rate Parity 227 8 Relationships among Inflation, Interest Rates, and Exchange Rates 257

PART 3: Exchange Rate Risk Management 295 9 Forecasting Exchange Rates 297 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 415 13 Direct Foreign Investment 417 14 Multinational Capital Budgeting 437 15 International Corporate Governance and Control 477 16 Country Risk Analysis 503 17 Multinational Capital Structure and Cost of Capital 527 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 697 Index 705

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Contents

Preface, xix

About the Author, xxvi

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, 11 1-3d Joint Ventures, 11 1-3e Acquisitions of Existing Operations, 11 1-3f Establishment of New Foreign Subsidiaries, 12 1-3g Summary of Methods, 12

1-4 Valuation Model for an MNC, 13 1-4a Domestic Model, 14 1-4b Multinational Model, 14 1-4c Uncertainty Surrounding an MNC’s Cash Flows, 17 1-4d Summary of International Effects, 20 1-4e How Uncertainty Affects the MNC’s Cost of Capital, 21

1-5 Organization of the Text, 21

2: INTERNATIONAL FLOW OF FUNDS 33 2-1 Balance of Payments, 33

2-1a Current Account, 33 2-1b Financial Account, 35 2-1c Capital Account, 36 2-1d Relationship between the Accounts, 37

2-2 Growth in International Trade, 37 2-2a Events That Increased Trade Volume, 37 2-2b Impact of Outsourcing on Trade, 39 2-2c Trade Volume among Countries, 40 2-2d Trend in U.S. Balance of Trade, 42

2-3 Factors Affecting International Trade Flows, 43 2-3a Cost of Labor, 43

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2-3b Inflation, 44 2-3c National Income, 44 2-3d Credit Conditions, 44 2-3e Government Policies, 44 2-3f Exchange Rates, 48

2-4 International Capital Flows, 52 2-4a Factors Affecting Direct Foreign Investment, 52 2-4b Factors Affecting International Portfolio Investment, 53 2-4c Impact of International Capital Flows, 53

2-5 Agencies That Facilitate International Flows, 55 2-5a International Monetary Fund, 55 2-5b World Bank, 56 2-5c World Trade Organization, 57 2-5d International Finance Corporation, 57 2-5e International Development Association, 57 2-5f Bank for International Settlements, 57 2-5g OECD, 58 2-5h Regional Development Agencies, 58

3: INTERNATIONAL FINANCIAL MARKETS 63 3-1 Foreign Exchange Market, 63

3-1a History of Foreign Exchange, 63 3-1b Foreign Exchange Transactions, 64 3-1c Foreign Exchange Quotations, 70 3-1d Derivative Contracts in the Foreign Exchange Market, 74

3-2 International Money Market, 75 3-2a European and Asian Money Markets, 76 3-2b Money Market Interest Rates among Currencies, 76 3-2c Risk of International Money Market Securities, 77

3-3 International Credit Market, 78 3-3a Syndicated Loans in the Credit Market, 78 3-3b Bank Regulations in the Credit Market, 79 3-3c Impact of the Credit Crisis, 79

3-4 International Bond Market, 80 3-4a Eurobond Market, 80 3-4b Development of Other Bond Markets, 81 3-4c Risk of International Bonds, 81 3-4d Impact of the Greece Crisis, 82

3-5 International Stock Markets, 83 3-5a Issuance of Stock in Foreign Markets, 83 3-5b Issuance of Foreign Stock in the United States, 84 3-5c Comparing the Size among Stock Markets, 85 3-5d How Governance Varies among Stock Markets, 86 3-5e Integration of International Stock Markets and Credit Markets, 87

3-6 How Financial Markets Serve MNCs, 88

Appendix 3: Investing in International Financial Markets, 95

4: EXCHANGE RATE DETERMINATION 103 4-1 Measuring Exchange Rate Movements, 103 4-2 Exchange Rate Equilibrium, 104

4-2a Demand for a Currency, 105 4-2b Supply of a Currency for Sale, 106

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4-2c Equilibrium Exchange Rate, 106 4-2d Change in the Equilibrium Exchange Rate, 107

4-3 Factors That Influence Exchange Rates, 108 4-3a Relative Inflation Rates, 109 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, 114 4-3g Influence of Factors across Multiple Currency Markets, 115 4-3h Impact of Liquidity on Exchange Rate Adjustments, 116

4-4 Movements in Cross Exchange Rates, 116 4-5 Capitalizing on Expected Exchange Rate Movements, 117

4-5a Institutional Speculation Based on Expected Appreciation, 118 4-5b Institutional Speculation Based on Expected Depreciation, 119 4-5c Speculation by Individuals, 120 4-5d The “Carry Trade”, 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, 141

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

Contents xi

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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, 198 6-2a Monetary Policy in the Eurozone, 198 6-2b Impact on Firms in the Eurozone, 199 6-2c Impact on Financial Flows in the Eurozone, 199 6-2d Impact of Eurozone Country Crisis on Other Eurozone Countries, 199 6-2e Impact of a Country Abandoning the Euro, 202

6-3 Direct Intervention, 203 6-3a Reasons for Direct Intervention, 203 6-3b The Direct Intervention Process, 204 6-3c Direct Intervention as a Policy Tool, 207 6-3d Speculating on Direct Intervention, 208

6-4 Indirect Intervention, 209 6-4a Government Control of Interest Rates, 209 6-4b Government Use of Foreign Exchange Controls, 210

Appendix 6: Government Intervention during the Asian Crisis, 218

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, 232 7-3a Covered Interest Arbitrage Process, 232 7-3b Realignment due to Covered Interest Arbitrage, 234 7-3c Arbitrage Example When Accounting for Spreads, 235 7-3d Covered Interest Arbitrage by Non-U.S. Investors, 236 7-3e Comparing Different Types of Arbitrage, 236

7-4 Interest Rate Parity (IRP), 236 7-4a Derivation of Interest Rate Parity, 237 7-4b Determining the Forward Premium, 238 7-4c Graphic Analysis of Interest Rate Parity, 240 7-4d How to Test Whether Interest Rate Parity Holds, 242 7-4e Does Interest Rate Parity Hold?, 242 7-4f Considerations When Assessing Interest Rate Parity, 243

7-5 Variation in Forward Premiums, 244 7-5a Forward Premiums across Maturities, 244 7-5b Changes in Forward Premiums over Time, 245

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8: RELATIONSHIPS AMONG INFLATION, INTEREST RATES, AND EXCHANGE RATES 257

8-1 Purchasing Power Parity (PPP), 257 8-1a Interpretations of Purchasing Power Parity, 257 8-1b Rationale behind Relative PPP Theory, 258 8-1c Derivation of Purchasing Power Parity, 258 8-1d Using PPP to Estimate Exchange Rate Effects, 259 8-1e Graphic Analysis of Purchasing Power Parity, 260 8-1f Testing the Purchasing Power Parity Theory, 263 8-1g Does Purchasing Power Parity Exist?, 265

8-2 International Fisher Effect (IFE), 266 8-2a Deriving a Country’s Expected Inflation Rate, 266 8-2b Estimating the Expected Exchange Rate Movement, 267 8-2c Implications of the International Fisher Effect, 267 8-2d Derivation of the International Fisher Effect, 270 8-2e Graphic Analysis of the International Fisher Effect, 272 8-2f Testing the International Fisher Effect, 273 8-2g Limitations of the IFE Theory, 274 8-2h IFE Theory versus Reality, 275 8-2i Comparison of IRP, PPP, and IFE Theories, 275

Part 2 Integrative Problem: Exchange Rate Behavior, 286 Midterm Self-Exam, 287

PART 3: Exchange Rate Risk Management 295

9: FORECASTING EXCHANGE RATES 297 9-1 Why Firms Forecast Exchange Rates, 297 9-2 Forecasting Techniques, 299

9-2a Technical Forecasting, 299 9-2b Fundamental Forecasting, 299 9-2c Market-Based Forecasting, 303 9-2d Mixed Forecasting, 306

9-3 Assessment of Forecast Performance, 307 9-3a Measurement of Forecast Error, 307 9-3b Forecast Errors among Time Horizons, 308 9-3c Forecast Errors over Time Periods, 308 9-3d Forecast Errors among Currencies, 308 9-3e Comparing Forecast Errors among Forecast Techniques, 309 9-3f Graphic Evaluation of Forecast Bias, 309 9-3g Statistical Test of Forecast Bias, 311 9-3h Shifts in Forecast Bias over Time, 312

9-4 Accounting for Uncertainty Surrounding Forecasts, 312 9-4a Sensitivity Analysis Applied to Fundamental Forecasting, 313 9-4b Interval Forecasts, 313

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

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10-2c Transaction Exposure Based on Value at Risk, 332 10-3 Economic Exposure, 335

10-3a Exposure to Foreign Currency Depreciation, 336 10-3b Exposure to Foreign Currency Appreciation, 337 10-3c Measuring Economic Exposure, 337

10-4 Translation Exposure, 340 10-4a Determinants of Translation Exposure, 340 10-4b Exposure of an MNC’s Stock Price to Translation Effects, 342

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, 357 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, 363 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, 374 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, 394 12-1b Restructuring to Reduce Economic Exposure, 395 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 Possible Strategies for Hedging Economic Exposure, 400

12-3 Managing Exposure to Fixed Assets, 401 12-4 Managing Translation Exposure, 402

12-4a Hedging Translation Exposure with Forward Contracts, 403 12-4b Limitations of Hedging Translation Exposure, 403

Part 3 Integrative Problem: Exchange Risk Management, 412

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PART 4: Long-Term Asset and Liability Management 415

13: DIRECT FOREIGN INVESTMENT 417 13-1 Motives for Direct Foreign Investment, 417

13-1a Revenue-Related Motives, 417 13-1b Cost-Related Motives, 418 13-1c Comparing Benefits of DFI among Countries, 420

13-2 Benefits of International Diversification, 421 13-2a Diversification Analysis of International Projects, 422 13-2b Diversification among Countries, 424

13-3 Host Government Impact on DFI, 424 13-3a Incentives to Encourage DFI, 425 13-3b Barriers to DFI, 425

13-4 Assessing Potential DFI, 427 13-4a A Case Study of Assessing Potential DFI, 427 13-4b Evaluating DFI Opportunities That Pass the First Screen, 429

14: MULTINATIONAL CAPITAL BUDGETING 437 14-1 Subsidiary versus Parent Perspective, 437

14-1a Tax Differentials, 437 14-1b Restrictions on Remitted Earnings, 438 14-1c Exchange Rate Movements, 438 14-1d Summary of Factors That Distinguish the Parent Perspective, 438

14-2 Input for Multinational Capital Budgeting, 439 14-3 Multinational Capital Budgeting Example, 441

14-3a Background, 441 14-3b Analysis, 442

14-4 Other Factors to Consider, 443 14-4a Exchange Rate Fluctuations, 444 14-4b Inflation, 447 14-4c Financing Arrangement, 447 14-4d Blocked Funds, 450 14-4e Uncertain Salvage Value, 451 14-4f Impact of Project on Prevailing Cash Flows, 452 14-4g Host Government Incentives, 453 14-4h Real Options, 453

14-5 Adjusting Project Assessment for Risk, 454 14-5a Risk-Adjusted Discount Rate, 454 14-5b Sensitivity Analysis, 454 14-5c Simulation, 457

Appendix 14: Incorporating International Tax Law in Multinational Capital Budgeting, 469

15: INTERNATIONAL CORPORATE GOVERNANCE AND CONTROL 477 15-1 International Corporate Governance, 477

15-1a Governance by Board Members, 477 15-1b Governance by Institutional Investors, 478 15-1c Governance by Shareholder Activists, 478

15-2 International Corporate Control, 479 15-2a Motives for International Acquisitions, 479 15-2b Trends in International Acquisitions, 479

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15-2c Barriers to International Corporate Control, 480 15-2d Model for Valuing a Foreign Target, 481

15-3 Factors Affecting Target Valuation, 482 15-3a Target-Specific Factors, 482 15-3b Country-Specific Factors, 483

15-4 A Case Study of Valuing a Foreign Target, 484 15-4a International Screening Process, 484 15-4b Estimating the Target’s Value, 485 15-4c Uncertainty Surrounding the Target’s Valuation, 487 15-4d Changes in Market Valuation of Target over Time, 487

15-5 Disparity in Foreign Target Valuations, 488 15-5a Expected Cash Flows of the Foreign Target, 488 15-5b Exchange Rate Effects on Remitted Earnings, 489 15-5c Required Return of Acquirer, 489

15-6 Other Corporate Control Decisions, 490 15-6a International Partial Acquisitions, 490 15-6b International Acquisitions of Privatized Businesses, 490 15-6c International Divestitures, 491

15-7 Corporate Control Decisions as Real Options, 492 15-7a Call Option on Real Assets, 492 15-7b Put Option on Real Assets, 493

16: COUNTRY RISK ANALYSIS 503 16-1 Country Risk Characteristics, 503

16-1a Political Risk Characteristics, 503 16-1b Financial Risk Characteristics, 506

16-2 Measuring Country Risk, 507 16-2a Techniques for Assessing Country Risk, 508 16-2b Deriving a Country Risk Rating, 509 16-2c Comparing Risk Ratings among Countries, 511

16-3 Incorporating Risk in Capital Budgeting, 512 16-3a Adjustment of the Discount Rate, 512 16-3b Adjustment of the Estimated Cash Flows, 512 16-3c Analysis of Existing Projects, 515

16-4 Preventing Host Government Takeovers, 516 16-4a Use a Short-Term Horizon, 516 16-4b Rely on Unique Supplies or Technology, 516 16-4c Hire Local Labor, 516 16-4d Borrow Local Funds, 516 16-4e Purchase Insurance, 517 16-4f Use Project Finance, 517

17: MULTINATIONAL CAPITAL STRUCTURE AND COST OF CAPITAL 527 17-1 Components of Capital, 527

17-1a Retained Earnings, 527 17-1b Sources of Debt, 528 17-1c External Sources of Equity, 529

17-2 The MNC’s Capital Structure Decision, 530 17-2a Influence of Corporate Characteristics, 531 17-2b Influence of Host Country Characteristics, 531 17-2c Response to Changing Country Characteristics, 532

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17-3 Subsidiary versus Parent Capital Structure Decisions, 533 17-3a Impact of Increased Subsidiary Debt Financing, 533 17-3b Impact of Reduced Subsidiary Debt Financing, 533 17-3c Limitations in Offsetting a Subsidiary’s Leverage, 534

17-4 Multinational Cost of Capital, 534 17-4a MNC’s Cost of Debt, 534 17-4b MNC’s Cost of Equity, 534 17-4c Estimating an MNC’s Cost of Capital, 535 17-4d Comparing Costs of Debt and Equity, 535 17-4e Cost of Capital for MNCs versus Domestic Firms, 536 17-4f Cost-of-Equity Comparison Using the CAPM, 537

17-5 Cost of Capital across Countries, 539 17-5a Country Differences in the Cost of Debt, 540 17-5b Country Differences in the Cost of Equity, 541

18: LONG-TERM DEBT FINANCING 551 18-1 Debt Denomination Decision 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 Identifying Debt Denomination Alternatives, 553 18-2b Analyzing Debt Denomination Alternatives, 554

18-3 Loans Facilitate 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, 559

18-5 Fixed versus Floating Rate Debt Decision, 560 18-5a Financing Costs of Fixed versus Floating Rate Loans, 560 18-5b Hedging Interest Payments with Interest Rate Swaps, 561

Part 4 Integrative Problem: Long-Term Asset and Liability Management, 572

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 (L/Cs), 583 19-2d Banker’s Acceptances, 583 19-2e Medium-Term Capital Goods Financing (Forfaiting), 586 19-2f Countertrade, 586

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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 20-1c Access to Funding during a Credit Crisis, 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, 613 21-2a Accommodating Cash Shortages, 614

21-3 Optimizing Cash Flows, 614 21-3a Accelerating Cash Inflows, 614 21-3b Minimizing Currency Conversion Costs, 615 21-3c Managing Blocked Funds, 617 21-3d Managing Intersubsidiary Cash Transfers, 617 21-3e Complications in Optimizing Cash Flow, 617

21-4 Investing Excess Cash, 618 21-4a Benefits of Investing in a Foreign Currency, 618 21-4b Risk of Investing in a Foreign Currency, 619 21-4c Hedging the Investment in a Foreign Currency, 620 21-4d Break-Even Point from Investing in a Foreign Currency, 621 21-4e Using a Probability Distribution to Enhance the Investment Decision, 622 21-4f Investing in a Portfolio of Currencies, 623 21-4g Dynamic Hedging, 625

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, 697

Index, 705

xvi i i Contents

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Preface

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

Intended Market International Financial Management, 13th Edition, presumes an understanding of basic corporate finance. It is suitable for both undergraduate and master’s level courses in in- ternational 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, 13th Edition, is organized to provide a background on the international environment and then to focus on the managerial aspects from a corporate perspective. Managers of MNCs will need to understand the environment be- fore 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 eco- nomic variables and explains the forces that influence 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 struc- ture decisions. Part 5 (Chapters 19 through 21) concentrates on the MNC’s management 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 the financing decisions depend on the investment decisions. Nevertheless, these concepts are explained with an emphasis on how the man- agement of long-term assets and long-term liabilities is integrated. For example, multina- tional capital budgeting analysis demonstrates how the feasibility of a foreign project may depend on the financing mix. Some professors may prefer to teach the chapters on managing long-term liabilities prior to teaching the chapters on managing long-term assets.

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The strategic aspects, such as motives for direct foreign investment, are covered before the operational aspects, such as short-term financing or investment. 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 be- yond what is in the text. For example, they may give less attention to the chapters in 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, 13th Edition, focuses on financial management de- cisions that maximize the value of multinational corporations. The text offers a variety of methods to reinforce key concepts so that instructors can select the 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/Counter-Point. A controversial issue is introduced, along with opposing arguments, and students are asked to determine which argument is correct and to explain why.

■ 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 the students to use their skills to write a short essay on a specific topic that was given attention 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 provide a combination of these. Integrative

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Problem. An integrative problem at the end of each part integrates the key concepts of 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 an- swers 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 inter- national business and apply key concepts from each chapter to run the business throughout the school term. The project is available in 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 and 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 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 13th edition have been updated to include recent developments in international financial markets, and in the tools used to manage a multinational corpo- ration. In particular, the following chapters were revised substantially:

■ Chapter 2 has been revised to reflect the balance-of-payments format that is consis- tent with the recent format used by the U.S. government for reporting the specific accounts.

■ Chapter 3 has been revised to improve flow between sections, and to update the manipulation of exchange rates in the foreign exchange market.

■ Chapter 6 now includes a section on black markets for currencies, and a section on the recent challenges of the European Central Bank (ECB) to stabilize financial conditions in the eurozone.

■ Chapter 8 has been revised substantially to synthesize the relationships between the Fisher effect, purchasing power parity (PPP), and the international Fisher effect (IFE).

■ Chapter 9 has been reorganized to improve the flow. ■ Chapter 10 has been revised to improve flow between sections, and to direct atten-

tion to the value at risk method for assessing exchange rate exposure. ■ Chapter 13 now includes a new case study example. ■ Chapter 14 now includes more detailed information about how managers (and stu-

dents) can use spreadsheets to facilitate the international capital budgeting process and apply sensitivity analysis.

■ Chapter 18 has been revised to improve the flow between sections.

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Online Resources The textbook companion site provides resources for both students and instructors.

Students: Access the following resources by going to www.cengagebrain.com and searching ISBN 9781337099738: Running Your Own MNC, International Investing Project, Discussion in the Boardroom, Key Terms Flashcards, and chapter Web links.

Instructors: Access textbook resources by going to www.cengage.com, logging in with your faculty account username and password, and using ISBN 9781337099738 to search for instructor resources or to add instructor resources to your account.

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 Dilem- mas, 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 flexible 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; de- liver tests from your LMS, your classroom, or wherever you want. The Cognero™ Test Bank contains the same questions that are in the Microsoft® Word Test Bank. All question content is now tagged according to Tier I (Business Program Interdis- ciplinary 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 are also available.

Additional Course Tools Cengage Learning Custom Solutions Whether you need print, digital, or hybrid course materials, Cengage Learning Custom Solu- tions can help you create your perfect learning solution. Draw from Cengage Learning’s exten- sive library of texts and collections, 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.

MindTap Feel confident as you use the most engaging digital content available to transform today’s students into critical thinkers. Personalize your course to match the way you teach and your students learn. Improve outcomes with real-time insight into student progress, and save time. All while your students engage with your course content, enjoy the flexibility of studying anytime and anywhere, stay connected with the MindTap Mobile app, and earn better grades.

MindTap Instant Access Code ISBN: 9781337270021.

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Acknowledgments Several professors reviewed previous versions of this text and influenced 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 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 Mohamamd 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 Krishnan, 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. Johns 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

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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 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 Poly- technic 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 influenced the content and organization of this edition, including Kevin Brady (Florida Atlantic 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), Nivine Richie (University of North Carolina – Wilmington), Garrett Smith (University of Wisconsin – Whitewater), Jurica Susnjara (Kean University), Alex Tang (Morgan 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.

xxiv Preface

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I appreciate the help and support from the people at Cengage Learning, including Joe Sabatino (Sr. Team Product Manager), Mike Reynolds (Retired), Nate Anderson (Marketing Manager), Brad Sullender and Stacey Lutkoski (Content Developers) and Denisse A Zavala-Rosales (Product Assistant). Special thanks are due to Nadia Saloom (Content Project Manager) and Nancy Ahr (Copyeditor) for their efforts to ensure a quality final product.

Jeff Madura Florida Atlantic University

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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 (in its 12th edition). His research on international finance has been pub- lished 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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Product Markets

Foreign Exchange Markets

Subsidiaries International

Financial Markets

Investing and FinancinggnitropmI dna gnitropxE

Dividend Remittance

and Financing

Multinational Corporation (MNC)

PART 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 flow of funds between countries. Chapter 3 describes the interna- tional financial markets and 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 understand the international environment described in these chapters in order to make proper decisions.

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Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

1 Multinational Financial Management: An Overview

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 eventually establish subsidiaries in foreign countries. Dow Chemical, IBM, Nike, and many other firms have more than half of their assets in foreign countries. Some businesses, such as ExxonMobil, Fortune Brands, and Colgate- Palmolive, commonly generate more than half of their sales in foreign countries. It is typical also for smaller U.S. firms to generate more than 20 percent of their sales in foreign markets; examples include Ferro (Ohio) and Medtronic (Minnesota). Many technology firms, such as Apple, Facebook, and Twitter, expand overseas in order to capitalize on their technology advantages. Many smaller private U.S. firms such as Republic of Tea (California) and Magic Seasoning Blends (Louisiana) generate a substantial percentage of their sales in foreign markets. Seventy-five percent of U.S. firms that export have fewer than 100 employees.

International financial management is important even to companies that have no international business. The reason is that 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.

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

■ identify the management goal and organizational structure of theMNC,

■ describe the key theories about why MNCs engage in international business,

■ explain the common methods used to conduct international business, and

■ provide a model for valuing the MNC.

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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 and thereby serve 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. However, these MNCs now place greater emphasis on satisfying shareholders; that way, the firm can more easily obtain funds from them to support its operations. Even in developing countries (e.g., Bulgaria and Vietnam) that have just recently encouraged the development of business enterprise, managers of firms must serve shareholder interests in order to secure their funding. There would be little demand for the stock of a firm that announced the proceeds would be used to over- pay managers or invest in unprofitable projects.

The focus of this text is on 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 apply generally also 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 max- imizes shareholder wealth. Management is used to develop 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 is used to increase consumer aware- ness about the products and to monitor changes in consumer preferences. Accounting and information systems are used to 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 is used to make investment and financing decisions for the MNC. Common finance decisions include:

■ whether to discontinue operations in a particular country, ■ whether to pursue new business in a particular country, ■ whether to expand business in a particular country, and ■ how to finance expansion in a particular country.

These finance decisions for each MNC are partially influenced by the other business discipline functions. The decision to pursue new business in a particular country is based on comparing the costs and potential benefits of expansion. The potential benefits of such new business depend on expected consumer interest in the products to be sold (marketing function) and expected cost of the resources needed to pursue the new busi- ness (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 make decisions that conflict with the firm’s goal of maximiz- ing shareholder wealth. For example, a decision to establish a subsidiary in one location versus another may be based on the location’s appeal to a particular manager rather than on its potential benefits to shareholders. A decision to expand a subsidiary may be

4 Part 1: The International Financial Environment

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motivated by a manager’s desire to receive more compensation rather than to enhance the value of the MNC. This conflict of goals between a firm’s managers and shareholders is often referred to as the agency problem.

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

EXAMPLE 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 manager in Singapore to manage the subsidiary. During the last two years, sales generated by the subsidiary have not grown. Even so, the manager hired several employees to do the work that he was assigned to do. The managers of the parent company in the United States have not closely monitored the subsidiary because it is so far away and because they trusted the manager there. Now they realize that there is an agency problem. The subsidiary is experienc- ing losses every quarter, so its management must be more closely monitored. l

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, England, made extremely risky trades. The subsequent investigation revealed that the bank had maintained poor internal control 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 and not of their respective subsidiaries. The parent can oversee subsidiary decisions to check whether each subsidiary’s managers are satisfy- ing the MNC’s goals. The parent also can implement compensation plans that reward those managers who satisfy the MNC’s goals. A common 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 subsid- iary, it created incentives for the manager of the subsidiary that aligned with the parent’s goal of maxi- mizing shareholder wealth. Specifically, it set up a compensation system whereby the manager’s annual bonus is based on the subsidiary’s earnings. l

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 thus induce managers to make decisions that satisfy the MNC’s shareholders. If these managers make poor decisions that reduce the MNC’s value, then another firm might acquire it at the lower price and hence would probably remove the weak managers. Moreover, institutional investors (e.g., mutual and pension funds) with large holdings of an MNC’s stock have some influence over management because they will complain to the board of directors if managers are making poor decisions.

Chapter 1: Multinational Financial Management: An Overview 5

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Institutional investors may seek to enact changes, including removal of high-level man- agers 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 exaggerate their performance. There are many well-known examples (such as Enron and WorldCom) in which large MNCs 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 executives and the board of directors. Some of the common methods used by MNCs to improve their internal control process are:

■ 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,

and ■ 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 central- ized 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 and thus 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 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.

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 while the par- ent’s management monitors those decisions to ensure they are in the MNC’s best interests.

6 Part 1: The International Financial Environment

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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

Chapter 1: Multinational Financial Management: An Overview 7

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How the Internet Facilitates Management Control The Internet simplifies the process for the parent to monitor the actions and performance of its foreign subsidiaries.

EXAMPLE Recall the example of Seattle Co., which has a subsidiary in Singapore. Using the Internet, the foreign sub- sidiary can e-mail updated information in a standardized format that reduces language problems and also send images of financial reports and product designs. The parent can then easily track the inventory, sales, expenses, and earnings of each subsidiary on a weekly or monthly basis. Thus using the Internet can reduce agency costs due to international aspects of an MNC’s business. l

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 the (1) theory of comparative advantage, (2) imperfect markets theory, and (3) product cycle theory. These theories overlap to some extent and can complement each other 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 advan- tages cannot easily be transported, countries tend to use their advantages to specialize in the production 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 while 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 com- parative advantage. Comparative advantages allow firms to penetrate foreign markets. Many of the Virgin Islands, for example, specialize in tourism and rely completely on international 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 interna- tional business. At the other extreme, if markets were perfect and thus the factors of production (such as labor) 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 and thus would remove 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. There are costs and often restrictions related to the transfer of labor and other resources used for production. There also may be restrictions on transferring funds and other resources among countries. Because mar- kets 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. Imperfect markets provide an incentive for firms to seek out foreign opportunities.

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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, firms become established in the home market as a result of some perceived advantage over existing competitors, such as a need by the mar- ket for at least one more supplier of the product. Because information about markets and competition is more readily available at home, a firm is likely to establish itself first in its home country. Foreign demand for the firm’s product will initially be accommodated by exporting. As time passes, the firm may feel the only way to retain its advantage over competition in foreign countries is to produce the product in foreign markets, thereby reducing its transportation costs. The competition in those foreign markets may increase as other producers become more familiar with the firm’s product. The firm may 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.

There is, of course, more to the product cycle theory than summarized here. This dis- cussion merely suggests that, as a firm matures, it may recognize additional opportunities outside its home country. 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. That advantage could be an edge in its production or financing approach that reduces costs or an edge in its marketing approach that generates and maintains a strong demand for its product.

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

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1-3 Methods to Conduct International Business Firms use several methods to conduct international business. The most common meth- ods are:

■ international trade, ■ licensing, ■ franchising, ■ joint ventures, ■ acquisitions of existing operations, and ■ establishment of new foreign subsidiaries.

Each method will be 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 pen- etrate 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 normally reduce or discontinue that part of its business at a low cost.

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

How the Internet Facilitates International Trade Many firms use their websites to list the products they sell along with the price for each product. This makes it easy for them to advertise their products to potential importers anywhere in the world without mailing brochures to various countries. Furthermore, a firm can add to its prod- uct line or change prices simply by revising its website. Thus importers need only check an exporter’s website periodically in order to keep abreast of its product information.

Firms also can use their websites to accept orders online. Some products, such as soft- ware, can be downloaded directly by the importer via the Internet. Other products must be shipped, but even in that case the Internet makes it easier to track the shipping pro- cess. An importer can transmit its order for products via e-mail to the exporter, and when the warehouse ships the products it can send an e-mail message to the importer and to the exporter’s headquarters. The warehouse may also use technology to monitor its inventory of products so that suppliers are automatically notified to send more sup- plies once the inventory falls below a specified level. If the exporter has multiple ware- houses, the Internet allows them to operate as a network; hence if one warehouse cannot fill an order, another warehouse will.

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 pro- duction plants in foreign countries, or transporting goods to foreign countries.

WEB

www.trade.gov/mas/ian

Outlook of international

trade conditions for each

of several industries.

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1-3c Franchising Under a franchising arrangement, one firm provides a specialized sales or service strat- egy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees, allowing local residents to own and manage the 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 an example, McDonald’s typi- cally purchases the land and establishes the building. It then leases the building to a fran- chisee 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, this is referred to as a direct foreign investment (DFI).

1-3d Joint Ventures A joint venture is a venture 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 already reside in those markets. Most joint ventures allow two firms to apply their respective comparative advantages in a given project. Joint 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, Inc., 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. 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 it is participating in the venture. Joint ventures between automobile manufacturers are numerous because each manufac- turer can offer its own technological advantages. General Motors has ongoing joint ven- tures with automobile manufacturers in several different countries, including the former Soviet states.

1-3e Acquisitions of Existing Operations Firms frequently acquire other firms in foreign countries as a means of penetrating for- eign 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 direct foreign investment because MNCs directly invest in a foreign country by purchasing the operations of target companies.

EXAMPLE Google, Inc., 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), and Sweden (videoconferencing). l

However, the acquisition of an existing corporation could lead to large losses because of the large investment required. In addition, if the foreign operations perform poorly then it may be difficult to sell the operations at a reasonable price.

Some firms engage in partial international acquisitions in order to obtain a toehold or stake in foreign operations. This approach requires a smaller investment than that of a

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full international acquisition and so exposes the firm to less risk. 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 coun- tries to produce and sell their products. Like a foreign acquisition, this method requires a large direct foreign investment. Establishing new subsidiaries may be preferred to foreign acquisitions because the operations can be tailored exactly to the firm’s needs. In addi- tion, 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.

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 subsidiaries require substantial investment in foreign operations and account for the largest portion of DFI.

Many MNCs use a combination of 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 pro- duce 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 direct foreign invest- ment, Nike’s international sales reached $1 billion by 1992 and now exceed $8 billion per year. l

The effects of international business on an MNC’s cash flows are illustrated in Exhibit 1.3. In general, the cash outflows 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 flows in the form of payment for its exports, fees for the services it provides within inter- national arrangements, and remitted funds from the foreign subsidiaries. The first diagram in this exhibit illustrates the case of an MNC that engages in international trade; its inter- national cash flows therefore result either from paying for imported supplies or from receiving payment in exchange for products that it exports.

The second diagram illustrates an MNC that engages in some international arrange- ments (which could include international licensing, franchising, or joint ventures). Any such arrangement may require cash outflows of the MNC in foreign countries to cover, for example, the expenses associated with transferring technology or funding partial

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investment in a franchise or joint venture. These arrangements generate cash flows for the MNC in the form of fees for services (e.g., 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. There can be cash outflows from the U.S. parent to its foreign subsidiaries in the form of invested funds to help finance the operations of the foreign subsidiaries. There are also cash flows from the foreign subsidiaries to the U.S. parent in the form of remitted earnings and fees for services provided by the parent; all of these flows can be classified as remitted funds from the foreign subsidiaries.

1-4 Valuation Model for an MNC The value of an MNC is relevant to its shareholders and its debt holders. When man- agers make decisions that maximize the firm’s value, they also maximize shareholder wealth (assuming that the decisions are not intended to maximize the wealth of debt holders at the expense of shareholders). 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. There are numerous methods of valuing an MNC, some of which lead to the same valuation. The method described in this section reflects the key factors affecting an MNC’s value in a general sense.

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 SubsidiariesMNC

Cash Inflows from Remitted Earnings

Cash Outflows to Finance the Operations

Chapter 1: Multinational Financial Management: An Overview 13

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1-4a Domestic 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 flows:

V ¼ Xn t¼1

EðCF$,t Þ ð1þ kÞt

( )

Here E(CF$,t) denotes expected cash flows to be received at the end of period t; n is the number of future periods in which cash flows are received; and k represents not only the weighted average cost of capital but also the required rate of return by investors and creditors who provide funds to the MNC.

Dollar Cash Flows The dollar cash flows in period t represent 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 flows are esti- mated from knowledge about various 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 flows and therefore can affect the firm’s value. Holding other factors constant, an increase in expected cash flows 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 affects the weighted average of its cost of capital and thus 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. Hold- ing other factors constant, an increase in the firm’s required rate of return will reduce the value of the firm because expected cash flows 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 flows are discounted at a lower required rate of return.

1-4b Multinational Model An MNC’s value can be specified in the same manner as a purely domestic firm’s value. However, consider that the expected cash flows 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.

The foreign currency cash flows will be converted into dollars. Thus the expected dol- lar cash flows to be received at the end of period t are equal to the sum of the products of cash flows denominated in each currency j multiplied by the expected exchange rate at which currency j could be converted into dollar cash flows by the MNC at the end of period t:

EðCF$,t Þ ¼ Xm j¼1 ½EðCFj ,t Þ � E ðSj,t Þ�

Here CFj,t represents the amount of cash flow denominated in a particular foreign currency j at the end of period t, and Sj,t denotes the exchange rate at which the foreign

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currency (measured in dollars per unit of the foreign currency) can be converted to dol- lars at the end of period t.

Valuation of an MNC That Uses Two Currencies An MNC that does busi- ness in two currencies could measure its expected dollar cash flows in any period by multiplying the expected cash flow in each currency by the expected exchange rate at which that currency could be converted to dollars and then summing those two products.

It may help to think of an MNC as a portfolio of currency cash flows, one for each currency in which it conducts business. The expected dollar cash flows derived from each of those currencies can be combined to determine the total expected dollar cash flows in the given period. It is easier to derive an expected dollar cash flow value for each currency before combining the cash flows among currencies within a given period, because each currency’s cash flow amount must be converted to a common unit (the dollar) before combining the amounts.

EXAMPLE Carolina Co. has expected cash flows of $100,000 from local business and 1 million Mexican pesos from business 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:

E ðCF$,t Þ¼ Xm j¼1 ½E ðCFj ,t Þ � E ðSj,t Þ�

¼ $ CF from U:S: operations þ  $ CF from operations in Mexico ¼ $ 100,000 þ  ½1,000,000 pesos �  ð$:09Þ� ¼ $ 100,000 þ  $ 90,000 ¼ $190,000:

The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars and therefore did not have to be converted. l

Valuation of an MNC That Uses Multiple Currencies The same process as just described can be employed to value an MNC that uses many foreign currencies. The general formula for estimating the dollar cash flows to be received by an MNC from multiple currencies in one period can be written as follows:

E ðCF$,t Þ ¼ Xm j¼1 ½EðCFj ,t Þ � EðSj,t Þ�

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, etc.). 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 euro forecast = $1.40, peso forecast = $.12, etc.). The existing exchange rate can be used as a forecast for the future exchange rate, but there are many alternative methods (as explained in Chapter 9). Third, multiply the amount of each foreign currency to be received by the fore- casted exchange rate of that currency in order to estimate the dollar cash flows to be received due to each currency. Fourth, add the estimated dollar cash flows for all 15 currencies in order 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 = 15 because there are 15 different currencies. l

Valuation of an MNC’s Cash Flows over Multiple Periods The entire process described in the example for a single period is not adequate for valuation because most MNCs have multiperiod cash flows. However, the process can be easily

Chapter 1: Multinational Financial Management: An Overview 15

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adapted to estimate the total dollar cash flows for all future periods. First, apply the same process described for a single period to all future periods in which the MNC will receive cash flows; this will generate an estimate of total dollar cash flows to be received in every period in the future. Second, discount the estimated total dollar cash flow for each period at the weighted cost of capital (k) and then sum these discounted cash flows to estimate the value of this MNC.

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

V ¼ Xn t¼1

Xm j¼1 ½E ðCFj ,t Þ� EðSj,t Þ�

ð1þ kÞt

8>>>>< >>>>:

9>>>>= >>>>;

Here CFj,t is the cash flow denominated in a particular currency (which may be dol- lars) and Sj,t denotes represents the exchange rate at which the MNC can convert the foreign to the domestic currency at the end of period t. Whereas the previous equation is applied to single-period cash flows, this equation considers cash flows over multiple periods and then discounts those flows to obtain a present value.

Because the management of an MNC should be focused 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 flows in a particular currency (CFj) or to conditions that increase the exchange rate at which that currency is converted into dollars (Sj).

To avoid double counting, cash flows of the MNC’s subsidiaries are considered in the valuation model only when they reflect transactions with the U.S. parent. Therefore, any expected cash flows received by foreign subsidiaries should not be counted in the valua- tion equation unless they are expected to be 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. Hence any decision by the MNC’s parent that affects the cost of its capital supporting projects in a specific country will also affect its weighted average cost of capital (and required rate of return) and thereby 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. The firm’s European earnings are denominated in euros (the currency of most European countries), and these earnings are typically remitted to the U.S. parent. Last year, Austin received $40 million in cash flows from its U.S. operations and 20 million euros from its Euro- pean operations. The euro was valued at $1.30 when remitted to the U.S parent, so Austin’s cash flows last year are calculated as follows:

 Austin’s total  $ cash flows last year ¼ $ cash flows from U:S: operationsþ $ cash flows from foreign operations

¼ $ cash flows from U:S: operationsþ ½ðeuro cash flowsÞ � ðeuro exchange rateÞ� ¼ $ 40,000,000þ ½ð20,000,000 eurosÞ � ð$1:30Þ� ¼ $ 40,000,000þ $ 26,000,000 ¼ $ 66,000,000

Assume that Austin Co. plans to continue its business 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. l

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1-4c Uncertainty Surrounding an MNC’s Cash Flows The MNC’s future cash flows (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 for- eign country’s economic conditions affect an MNC’s cash flows, they affect the MNC’s valuation. The cash inflows that an MNC receives from sales in a foreign country during a given period depends on the demand by that country’s consumers for the MNC’s pro- ducts, which in turn is affected by that country’s national income in that period. If eco- nomic conditions 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. This illustrates how the MNC’s cash flows increasing because of its exposure to interna- tional economic conditions.

However, an MNC can also be adversely affected by its exposure to international eco- nomic conditions. If conditions weaken in the foreign country where the MNC does business, that country’s consumers suffer a decrease in their income and the employment rate may decline. Then those consumers have less money to spend, and their demand for the MNC’s products will decrease. In this case, the MNC’s cash flows are reduced because of its exposure to international economic conditions.

When Facebook went public in 2012, the registration statement acknowledged its exposure to international economic conditions: “We plan to continue expanding our operations abroad where we have limited operating experience and may be subject to increasing business and economic risks that could affect our financial results.”

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

V 5 ^ n

t51

^ [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

Chapter 1: Multinational Financial Management: An Overview 17

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

International economic conditions can also affect the MNC’s cash flows indirectly by affecting the MNC’s home economy. Consider that when a country’s economy strength- ens and hence its consumers buy more products from firms in other countries, the firms in those other countries experience stronger sales and cash flows. Therefore, the owners and employees of these firms have more income. When they spend a portion of that higher income locally, they stimulate their local economy.

Conversely, if the foreign country’s economy weakens and hence its consumers buy fewer products from firms in other countries, then the firms in those countries experi- ence weaker sales and cash flows. The owners and employees of these firms therefore have less income, and if they reduce spending locally their local economy weakens.

There is much international trade between the United States and Europe. European countries under weak economic conditions tend to reduce their demand for U.S.-made products. The result may be weaker economic conditions in the United States, which may lead to lower national income and higher unemployment there. Then U.S. consu- mers would have less money to spend and so would reduce their demand for the pro- ducts offered by U.S.-based MNCs. In recent years, the financial press has featured extensive coverage on how bad economic conditions in European countries adversely affect the U.S economy. Similarly, research has documented that U.S. stock market per- formance is highly sensitive to economic conditions in Europe.

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