Multinational Financial Management International Corporate Finance

Multinational Financial Management International Corporate Finance P.V. Viswanath

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. P.V. Viswanath 2

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. P.V. Viswanath 3

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. P.V. Viswanath 4

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. P.V. Viswanath 5

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 P.V. Viswanath 6

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. P.V. Viswanath 7

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. P.V. Viswanath 8

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. P.V. Viswanath 9

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. P.V. Viswanath 10

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 1:1.33. Suppose the terms of trade are 1:1. This is consistent with the withincountry prices given below. Coal Wheat US 30/ton 30/ton UK 30/ton 30/ton P.V. Viswanath 11

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. P.V. Viswanath 12

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. P.V. Viswanath 13

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. P.V. Viswanath 14

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. P.V. Viswanath 15

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. P.V. Viswanath 16

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 P.V. Viswanath 17