Multinational Financial Management

1
Multinational Financial Management

• International Corporate Finance
• P.V. Viswanath

2
The Multinational Enterprise

• A multinational corporation is a company engaged
  in producing and selling goods or services in
  more than one country. Usually, it consists of a
  parent company located in the home country and
  several foreign subsidiaries.
• A multinational is characterized more by attitude
  than the physical reality of an integrated system
  of marketing and production activities worldwide.
• Where in the world should we build our plants,
  sell our products, raise capital, and hire
  personnel? i.e. a global perspective, rather
  than the perspective of the home country, where
  the parent is located.

3
Relevance of International Finance

• Many of the problems of multinational firms are
  due to the use of different currencies used in
  different countries and the consequent need to
  exchange them.
• There are political divisions as well as currency
  divisions between countries.
• A financial manager has to decide how
  international events will affect a firm and what
  steps can be taken to exploit positive
  developments and insulate the firm from harmful
  ones.

4
Relevance of International Finance

• Relevant variables are changes in exchange rates,
  interest rates, inflation rates and asset values.
• However, these variables are interconnected.
• Hence foreign exchange risk is not simply added
  to other business risks. The amount of risk
  depends crucially on the way exchange rates and
  other financial prices are connected.

5
Relevance of International Finance

• Even companies that operate only domestically but
  compete with firms producing abroad and selling
  in their local market are affected by
  international developments.
• Thus, US appliance manufacturers with no overseas
  sales will find US sales and proift margins
  affected by exchange rates which influence the
  dollar prices of imported appliances.

6
Outline

• Basis for international trade
• We will look at why there is international trade
  and on what basis trade occurs, i.e. who exports
  what to whom.
• How multinationals fit into the traditional
  theory
• What is the role of multinationals in
  international trade

7
Doctrine of Absolute Advantage
Number of units of factors of production required
per unit of final product
Coal Wheat
US 2 units/ton 1 unit/ton
Germany 1 unit/ton 4 units/ton
Since the US is more efficient in the production
of wheat, it will produce wheat Germany is more
efficient in the production of coal hence it
will produce coal. The US will export wheat to
the Germany and import coal. Assumptions 1)
Factors of production cannot move freely across
countries. 2) Factors of production are not
specialized.
8
Doctrine of Comparative Advantage
Number of units of factors of production required
per unit of final product
Coal Wheat
US 2 units/ton 1 unit/ton
UK 3 units/ton 4 units/ton
Even though the US is more efficient in the
production of both wheat and coal, it has a
comparative advantage in the production of wheat
hence, it will produce wheat the UK has a
comparative advantage in producing coal hence it
will produce coal. The US will export wheat to
the UK and import coal.
9
Gains from Trade

• Prior to the introduction of trade, the exchange
  rate between wheat and coal in the US and UK must
  be as follows

US 1 ton wheat 0.5 tons of coal
UK 1 ton wheat 1.33 tons of coal
Clearly, UK producers of coal will find it
advantageous to sell their coal to the US, since
they can get more than 0.75 tons of wheat for
each ton of coal. Similarly, US producers of
wheat can get more if they sold to the UK than
the 0.5 ton of coal they could get in the US.
Hence, the final terms of trade, i.e. the common
exchange rate after trade is introduced will be
somewhere between the two exchange rates, above.
For example, it might be 1 ton of wheat 1 ton
of coal. Exactly where it will be, will depend
upon the demand and supply schedules for coal and
wheat.
10
Specialized Factors of Production

• If some factors are specialized, i.e. relatively
  more efficient in the production of one commodity
  rather than the other, the prices of the factors
  that specialize in the commodity that is exported
  will gain because of greater demand, once trade
  begins.
• This is because demand for a factor is a derived
  demand and is based on demand for the goods that
  the factors produce.
• US producers of coal that cannot switch to wheat
  production will be hurt, since the demand for
  their product will drop.
• The greater the gains from trade for a country
  overall, the greater the cost of trade to those
  factors of production that specialize in
  producing the commodity, now imported.

11
Monetary Prices and Exchange Rates

• Suppose before the start of trade, each
  production unit costs 30 in the US and 10 in
  the UK. Then the prices of wheat and coal in the
  two countries will be

Coal Wheat
US 60/ton 30/ton
UK 30/ton 40/ton
After trade begins, terms of trade will equalize
between countries we can have any rate of
exchange between 1 wheat 0.5 coal or 11.33.
Suppose the terms of trade are 11. This is
consistent with the within-country prices given
below.
Coal Wheat
US 30/ton 30/ton
UK 30/ton 30/ton
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Monetary Prices and Exchange Rates

• What about the exchange rate? Suppose the
  exchange rate were 3 1, then the
  dollar-equivalent prices would be

Coal Wheat
US 30/ton 30/ton
UK 90/ton 90/ton
At these prices, all coal and wheat would be
produced in the US and exported to the UK.
Factors of production in the UK would be idle and
the UK will have a massive trade deficit. The US
will be prosperous and the UK will have massive
unemployment and depression. Obviously, such a
situation cannot continue it is not an
equilibrium situation.
13
Exchange Rate Equilibrium

• The British demand for dollars to buy US wheat
  and coal will raise the value of the dollar.
  This will make US products more expensive to the
  British and British goods less expensive to
  Americans.
• This will continue until the exchange rate
  stabilizes at 1 1, which is an equilibrium
  rate.
• If factors of production are specialized, then
  the jump in demand for US factors of production
  will raise their prices and hence the cost of
  producing US coal and wheat will rise.
• British products will become more attractive to
  Americans and American products will become less
  attractive to the British.
• This process will continue until both countries
  find their comparative advantage and the terms of
  trade between coal and wheat are equal in both
  countries. The exchange rate will also have to
  adjust so that dollar costs of production are
  equalized across countries.

14
Factor Price Equalization

• The shift in the demand for factors of production
  in the two countries should cause factor prices
  to equalize.
• However, this will happen only if free trade is
  not impeded.
• If trade is not free, i.e. goods and services
  cannot move across borders, factors of production
  may move, if permitted.

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The Role of the Multinational Firm - I

• Does the Multinational Corporation represent
  movement of capital?
• The theory of comparative advantage rests on
  factor differences across countries. However,
  when countries become increasingly homogenous,
  other factors might determine trade.

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The Role of the Multinational Firm - II

• Economies of scale might require a transnational
  entity.
• Improved communications permit intermediate
  commodities to be traded the example of the
  Barbie doll.
• Cultural predilections, historical accidents and
  government policies, differences in attitudes to
  labor/unions.
• Development of International Finance raising
  capital abroad, sharing risk across borders, tax
  arbitrage, need for diversification.

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Financial Issues for the Multinational Firm

• foreign exchange risk management
• managing working capital and the internal
  financial system
• financing foreign units
• capital budgeting
• evaluation and control