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Chapter 1: Multinational Financial Management: AnOverview
Goal of the MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth.
Some MNCs are former state-owned companies where governments remain an important shareholder. Such
companies seek stock market quotes to raise finance and therefore have to demonstrate by means of the
annual accounts and report that they are maximizing shareholder wealth in the same way as a wholly privately-
owned company.
Such companies may benefit more from government support.
The blockholder system: fewer, larger stakeholders in companies with corporate governance laws that seek to
protect creditors and employees.
Continental Europe
The UK-US market-based approach has far more dispersed ownership and much greater emphasis on
shareholders’ rights.
Conflicts with The MNC Goal
Agency theory
The formal relationship between the employees of a company and the shareholders is part of the concept of
corporate governance: the system by which companies are directed and controlled.
There is a strong underlying assumption that the directors and hence all whom they employ in act in the best
interest of the shareholders.
Agency theory drops the assumption that directors always act in the best interests of shareholders and accepts
that managers of a firm may make decisions that conflict with the firm’s goal to maximize shareholder wealth.
When a firm has only one owner who is also the sole manager, such a conflict of goals does not occur.
This conflict of goal is often referred to as the agency problem.
The costs of ensuring that managers maximize shareholder wealth (agency costs) are normally larger for MNCs
than for purely domestic firms for several reasons:
1. MNCs with subsidiaries scattered around the world may experience larger agency problems because
monitoring managers of distant subsidiaries in foreign countries is more difficult.
2. Foreign subsidiary managers raised in different cultures may treat the goals of its MNC in a different
way from that intended by the senior management.
3. The sheer size of the larger MNCs can also create communication problems.
4. The complexity of operations may result in decisions for foreign subsidiaries of the MNCs that are
inconsistent with maximizing shareholder wealth of the company as a whole.
The temptation to pursue ones’ own goals either personal or that of a subsidiary at the expense of the overall
goal is referred to as moral hazard.
The higher level of agency theory is that of the principal who sets the goals and monitors the actions of the
agent who carries out the tasks either directly or indirectly. The principal is also responsible for the rewards
which are geared towards encouraging the agent to meet the principal’s goals.
Where an agent consumes resources to meet their own ends, this is referred to as consumption of perquisites;
this can be directly in the form of high expenses or indirectly by substituting leisure for work!
Monitoring is necessary to reduce moral hazard particularly where the principal does not have good knowledge
of the agent’s actions.
,The term that is used in cases where the agent knows more than the principal is information asymmetry.
A centralized management style can reduce agency costs because it allows managers of the parent direct
control of foreign subsidiaries and therefore reduces the power of subsidiary managers.
A decentralized management style is more likely to result in higher agency costs because subsidiary managers
may make decisions that do not focus on maximizing the value of the entire MNC. Yet, this style gives more
control to those managers who are closer to the subsidiary’s operations and environment.
The internet is making it easier for the parent to monitor the actions and performance of its foreign
subsidiaries.
External influences
An important motive for internal control is to be able to manage threats to a company from the competitive
environment.
Hostile takeover threat if the MNC is inefficiently managed:
In theory, this threat is supposed to encourage directors to make decisions that enhance the value of
MNCs.
It is also in the interest of the directors to ensure good motivation and control of lower levels of
management.
A second form of external influence is the monitoring by individuals, pressure groups and institutions, all of
whom are major shareholders in the stock market.
Order flow models, this is the buy and sell orders in the market, are viewed as evidence of possible insider
information and hence information asymmetry.
Constraints interfering with the MNC’s goal
Environmental constraints
Regulatory constraints
Ethical constraints
The dilemma facing MNCs can be seen as whether standard should be relative (conforming to the law and
practices of each country separately) or absolute (one set of values applied worldwide).
Theories of International Business
Economic theories address the problem at national level, looking at how countries can increase their overall
level of wealth through international trade.
They are normative.
Business theories are based on observation: they seek to find common patterns of development of
international business and model these patterns into a coherent explanation.
Economic theories
The theory of absolute advantage: through better use of resources by means of specialization, the world totals
of (for example) food and machinery are now higher than before specialization. Both parties can be better off
through specialization and free international trade.
Each country specializes in the good which it is most efficient in.
The law of comparative advantage: if each country produced more of the product at which it was
comparatively less inefficient, it was still possible for world production levels of food and machinery to increase
and both parties could still benefit through international trade.
One country is less efficient in producing both products.
,The Heckscher-Ohlin theorem translates the ideas of productivity and resource abundance to the price
mechanism.
A common argument is that as knowledge and the factors of production is now much more transferable than in
the past, the comparative advantage for a country is in having cheaper labor due to lower standards of living.
Race to the bottom
Business theories
The product cycle theory: firms first become established in the home market to meet local demand. A lack of
information and a lack of resources create a preference for single market development. Where the product is
successful, the firm will experience foreign demand for its products from exporters, foreign companies or even
via the Internet from foreign customers. 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 it
transportation costs.
Firm evolves into MNC
Global strategies: where there is already a strong international market, firms need to produce and sell
internationally to protect their sales.
International Business Methods
Firms use several methods to conduct international business. The most common are:
1. International trade
2. Licensing
3. Franchising
4. Joint ventures
5. Acquisitions of existing operations
6. Establishing new foreign subsidiaries
7. Special Purpose Vehicles
International trade
Trading rather than investing abroad is a relatively conservative approach to international business that can be
used by firms to penetrate markets (by exporting) or to obtain supplies at a low cost (by importing).
Minimal risk because there is no investment of any capital abroad.
Licensing
Licensing involves selling copyrights, patents, trademarks or trade names or legal rights in exchange for fees
known as royalties. Thus, a company is selling the right to produce their goods.
It allows firms to use their technology in foreign markets without a major investment in foreign
countries and without the transportation costs that result from exporting.
Disadvantage: it is difficult for the firm providing the technology to ensure quality control in the foreign
production process.
Franchising
Under a franchising agreement the franchisor provides a specialized sales or service strategy, support
assistance and possibly an initial investment in the franchise in exchange for periodic fees.
It allows firms to penetrate foreign markets without a major investment in foreign countries.
Joint venture
A joint venture is a venture that is owned and operated by two or more firms. Most joint ventures allow two
firms to apply their respective comparative advantages in a given project.
Acquisitions of existing operations
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign markets. They allow
firms to have full control over their foreign business and to quickly obtain a large portion of foreign market
share.
, Establishing new foreign subsidiaries
Firms can also penetrate foreign markets by establishing new operations in foreign countries to produce and
sell their products.
Can be tailored exactly to the firm’s needs.
Special Purpose Vehicles
These are separate companies set up by the one or more sponsoring MNCs to exploit a particular project. The
SPV is legally and financially independent of the sponsors and other providers of capital. The success of the SPV
depends on the project’s ability to repay the contracted debt and reward the sponsors.
For larger companies, the attraction is more in the way in which SPV isolates the MNC from downside risk (the
risk of a loss).
There is also the less virtuous motive of the activity being less visible as the SPV appears as an investment
rather than the constituent assets and liabilities.
Summary of methods
Any method of increasing international business that requires a direct investment in foreign operations
normally is referred to as a foreign direct investment (FDI) and is generally defined as investments abroad
where there is at least a 10% ownership interest.
International trade and licensing usually are not considered to be FDI: they do not involve direct
investment in foreign operations.
Franchising and joint ventures tend to require some investment in foreign operations, but to a limited
degree.
Foreign acquisitions and the establishment of new foreign subsidiaries require substantial investment
in foreign operations and respect the largest portion of FDI.
Exposure to International Risk
International business increases an MNC’s exposure to:
1. Exchange rate movements
2. Foreign economic conditions
3. Political risk
Exposure to exchange rate movements
Most international business results in the exchange of one currency for another to make the payment. Since
exchange rates fluctuate on a daily basis, the cash outflows required to make payments change accordingly.
Exposure to foreign economies
When MNCs enter foreign markets to sell products, the demand for these products is dependent on the
economic conditions in those markets. Thus, the cash flows of the MNC are subject to foreign economic
conditions.
Exposure to political risk
Political risk arises because the host government or the public may take actions that affect the MNC’s cash
flows.
It is often viewed as a subset of country risk.
Overview of an MNC’s Cash Flows
Because of the MNCs’ international operations their cash flow streams differ from those of purely domestic
firms.
An MNC whose only business is international trade
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