Solutions for Multinational Financial Management, 12th Edition Shapiro
Chapter 1
Introduction: Multinational Corporations and Financial Management
Learning Objectives
• To understand the nature and benefits of globalization
• To explain why multinational corporations are the key players in international
economic competition today
• To understand the motivations for foreign direct investment and the evolution of the
multinational corporation (MNC)
• To identify the stages of corporate expansion overseas by which companies gradually
become MNCs
• To explain why managers of MNCs need to exploit rapidly changing global economic
conditions and why political policymakers must also be concerned with the same
changing conditions
• To identify the advantages of being multinational, including the benefits of
international diversification
• To describe the general importance of financial economics to multinational financial
management
Background
Chapter 1 emphasizes the internationalization of business and economic activity that has
occurred since the end of World War II. Although international business activities have
existed for centuries, primarily in the form of exporting and importing, it is only in the
postwar period that multinational firms have become preeminent. The distinguishing
characteristic of the MNC is its emphasis on global, rather than affiliate, performance.
Specifically, MNCs ask, “Where in the world should we build our plants, sell our
products, raise capital, and hire personnel?” Thus the true multinational is characterized
more by attitude than the physical reality of an integrated system of marketing and
production activities worldwide. It involves looking beyond the boundaries of the home
country, and treating the world as “our oyster.” Good examples include the globalization
of GE's medical systems division and Arco Chemical.
After stimulating student interest with this vision of the MNC, I then introduce the
financial decisions that multinationals must make. I begin by discussing the key concepts
and lessons from domestic finance that apply directly to international corporate finance.
The lessons include the emphasis on cash flow rather than accounting earnings, the time
value of money, the importance of taxes, and the unwillingness of investors to reward
companies for activities (like corporate diversification) which investors could replicate
for themselves at no greater cost.
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The key concepts, which I point out will arise time and again in the course, are arbitrage,
market efficiency, and the separation of risk into systematic risk, which must be
rewarded, and unsystematic risk, which is not rewarded. The latter concept, of course, is
the intuition underlying both the capital asset pricing model (CAPM) and the arbitrage
pricing theory (APT). Although imperfect, the theoretical framework of domestic
corporate finance provides a useful frame of reference, and understanding it is essential
before proceeding with the more complex aspects of international financial management.
I devote some time to explaining that total risk matters, even if the CAPM or APT holds.
Otherwise the astute student will see a conflict between the irrelevance of unsystematic
risk and hedging activities.
I then outline the key decision areas in international financial management: foreign
exchange risk management, managing working capital and the internal financial system,
financing foreign units, capital budgeting, and evaluation and control. I emphasize the
additional parameters that MNC financial executives must cope with, including multiple
currencies, rates of inflation, tax systems, and capital markets, as well as foreign
exchange and political risks.
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Suggested Answers to Chapter 1 Questions
1.1.a. What are the various categories of multinational firms?
ANSWER. Raw materials seekers, market seekers, and cost minimizers.
b. What is the motivation for international expansion of firms within each category?
ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be
found there. It just happens that nature didn't place all natural resources domestically.
Market seekers go overseas to produce and sell in foreign markets. The cost minimizers
invest in lower-cost production sites overseas in order to remain cost competitive both at
home and abroad. In all cases, the firms involved recognize that the world is larger than
the home country and provides opportunities to gain additional supplies, sell more
products or find lower cost sources of production.
1.2.a. How does foreign competition limit the prices that domestic companies can
charge and the wages and benefits that workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less
expensive goods and services supplied by foreign producers. The likelihood of losing
sales limits the prices that domestic firms can charge. Foreign competition also acts to
limit the wages and benefits that workers can demand. If workers demand more money,
firms have two choices. Acquiesce in these demands or fight them. Absent foreign
competition, the cost of acquiescence is relatively low, particularly if the industry is
unionized. Since all firms will face the same higher costs, they can cover these higher
costs by all of them simultaneously raising their prices without fear of being undercut or
of being placed at a competitive disadvantage relative to their peers. Foreign competition
changes the picture since foreign firms' costs will be unaffected by higher domestic
wages and benefits. If domestic firms give in on wages and benefits, foreign firms will
underprice them in the market and take market share away. In this case, higher domestic
costs will put domestic firms at a disadvantage vis-à-vis their foreign competitors.
Recognizing this, domestic firms facing foreign competition are more likely to fight
worker demands for higher wages and benefits.
b. What political solutions can help companies and unions avoid the limitations imposed
by foreign competition?
ANSWER. The classic political solution is protectionism. By limiting foreign competition,
either through tariffs or quotas, companies and workers limit the ability of foreign goods
to restrain domestic price increases. The government can also subsidize domestic firms in
competing against foreign firms. These subsidies allow domestic firms and unions to
perpetuate uneconomic work rules, wages, and productions processes.
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c. Who pays for these political solutions? Explain.
ANSWER. Consumers pay for protectionism in the form of higher prices for their goods
and service, fewer choices, and lower quality. These consumers include firms that use
imports to produce their own goods and services for sale. Taxpayers pay for subsidies in
the form of higher taxes or fewer of the other services provided by government.
1.3.a. What is an efficient market?
ANSWER. An efficient market is one in which new information is readily incorporated in
the prices of traded securities. In an efficient market one cannot expect to prosper by
finding overvalued or undervalued assets. In addition, all funds require the same
risk-adjusted returns. Absent tax considerations or government intervention, therefore,
market efficiency suggests that there are no financing bargains available.
b. What is the role of a financial executive in an efficient market?
ANSWER. In an efficient market, attempts to increase the value of a firm by purely
financial measures or accounting manipulations are unlikely to succeed unless there are
capital market imperfections or asymmetries in tax regulations. The net result of these
research findings has been to focus attention on those areas and circumstances in which
financial decisions and financial managers can have a measurable impact. The key areas
are capital budgeting, working capital management, and tax management. The
circumstances to be aware of include capital market imperfections, caused primarily by
government regulations, and asymmetries in the tax treatment of different types and
sources of revenues and costs. As such, the role of the financial manager is to search for
and take advantage of capital market imperfections and tax asymmetries to increase after-
tax profits and lower the cost of capital. As noted in the chapter, the value of good
financial management is enhanced in the international arena because of the much greater
likelihood of market imperfections and multiple tax rates. In addition, the greater
complexity of international operations is likely to increase the payoffs from a
knowledgeable and sophisticated approach to internationalizing the traditional areas of
financial management.
1.4.a. What is the capital asset pricing model?
ANSWER. The CAPM quantifies the relevant risk of an investment and establishes the
trade-off between risk and return; i.e., the price of risk. It posits a specific relationship
between diversification, risk, and required asset returns. In effect, the CAPM says that the
required return on an asset equals the risk-free return plus a risk premium based on the
asset's systematic or nondiversifiable risk. The latter is based on market-wide influences
that affect all assets to some extent, such as unpredictable changes in the state of the
economy or in some macroeconomic policy variable, such as the money supply or the
government deficit.
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