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Multinational FinancialManagement

International Corporate Finance

P.V. Viswanath


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P.V. Viswanath 2

The Multinational Enterprise

A multinational corporation is a company engaged inproducing and selling goods or services in more than onecountry. Usually, it consists of a parent company located inthe home country and several foreign subsidiaries.

A multinational is characterized more by attitude than thephysical reality of an integrated system of marketing andproduction activities worldwide.

Where in the world should we build our plants, sell our

products, raise capital, and hire personnel? i.e. a globalperspective, rather than the perspective of the home country,where the parent is located.


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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 divisionsbetween 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 harmfulones.


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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.


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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 pricesof imported appliances.


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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


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Doctrine of Absolute Advantage

Coal Wheat

US 2 units/ton 1 unit/ton

Germany 1 unit/ton 4 units/ton

Number of units of factors of production required per unit

of final product

Since the US is more efficient in the production of wheat, it will producewheat; 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.



Doctrine of Comparative Advantage

Coal Wheat

US 2 units/ton 1 unit/ton

UK 3 units/ton 4 units/ton

Number of units of factors of production required per unit

of final product

Even though the US is more efficient in the production of bothwheat 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.



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.



Specialized Factors of Production

If some factors are specialized, i.e. relatively more efficientin the production of one commodity rather than the other,the prices of the factors that specialize in the commodity thatis 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 thatspecialize in producing the commodity, now imported.



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 within-country prices given below.

Coal Wheat

US $30/ton $30/ton

UK 30/ton 30/ton


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Exchange Rate Equilibrium

The British demand for dollars to buy US wheat and coal will raisethe value of the dollar. This will make US products more expensiveto 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 ofproducing 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 inboth countries. The exchange rate will also have to adjust so thatdollar costs of production are equalized across countries.



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 maymove, if permitted.



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.



The Role of the Multinational Firm - II

Economies of scale might require a transnationalentity.

Improved communications permit intermediate

commodities to be tradedthe example of the Barbiedoll.

Cultural predilections, historical accidents andgovernment policies, differences in attitudes to

labor/unions. Development of International Financeraising capital

abroad, sharing risk across borders, tax arbitrage, needfor diversification.


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Financial Issues for the MultinationalFirm

foreign exchange risk management

managing working capital and the internal financialsystem

financing foreign units

capital budgeting

evaluation and control

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