Chapter 1

Multinational Financial
Management: Opportunities and
Challenges
Edited and prepared by K.Y. Leong
Copyright © 2021 Pearson Education Ltd. All Rights Reserved
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Learning Objectives

1.1 Explore the global financial marketplace—players and playing

field

1.2 Consider how the theory of comparative advantage applies to

multinational business

1.3 Examine how international financial management differs from

domestic financial management

1.4 Discover the steps and stages of the globalization process

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The Multinational Enterprise (MNE)

• The October–December 2014 quarter was a challenging one with unprecedented
currency devaluations. Virtually every currency in the world devalued versus the
U.S. dollar, with the Russian Ruble leading the way. While we continue to make
steady progress on the strategic transformation of the company—which focuses P&G
on about a dozen core categories and 70 to 80 brands, on leading brand growth, on
accelerating meaningful product innovation and increasing productivity savings—the
considerable business portfolio, product innovation, and productivity progress was not
enough to overcome foreign exchange.
—P&G News Release, January 27, 2015

• A multinational enterprise (MNE) has operating branches, subsidiaries,

or affiliates located in foreign countries.
• Today, digital startups can become multinational enterprises in hours

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The Multinational Enterprise (MNE)
• Have operations in more than one country
• Include for profit, non-profit firms, and NGOs
• Reliance on emerging markets for…
• New world markets:
• BRICs (Brazil, Russia, India, and China)
• BIITS (Brazil, India, Indonesia, Turkey, and South Africa)
• MINTs (Mexico, Indonesia, Nigeria, and Turkey)

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The Global Financial Marketplace

• Assets, institutions, and linkages comprise one method to
map global capital markets (see Exhibit 1.1).
• Assets are debt securities issued by governments (e.g.,
U.S. Treasury Bonds). These form the baseline for other
forms of financing.
• Institutions are the central banks, commercial, and
investment banks. Their health keeps the global financial
system stable.
• Linkages are the interbank networks using currency.
Without ready exchange of currencies the market is hard-
pressed to operate efficiently, through the international
interbank market, primary price: LIBOR
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Exhibit 1.1 Global Capital Markets

The global capital market is a collection of institutions (central banks, commercial banks,
investment banks, not-for profit financial institutions like the I M F and World Bank) and
securities (bonds, mortgages, derivatives, loans, etc.), which are all linked via a global
network-the Interbank Market. This interbank market, in which securities of all kinds are
traded, is the critical pipeline system for the movement of capital.

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Exhibit 1.1 Global Capital Markets

The exchange of securities-the movement of capital in the global financial

system-must all take place through a vehicle-currency. The exchange of
currencies is itself the largest of the financial markets. The interbank market,
which must pass-through and exchange securities using currencies, bases
all of its pricing through the single most widely quoted interest rate in the
world- L I B O R (the London Interbank Offered Rate).
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The Market for Currencies

• The price of any one country’s currency quoted in another
country’s currency is a foreign currency exchange rate.

• Most currencies including €, £, ¥ are quoted against the dollar

($ or USD) as in “so many units per dollar.” eg: £/$ (pound per
dollar), RM/$ (Ringgit per dollar), ¥/$ (Yen per dollar).

• A few are quoted as “dollars per unit” due to custom

e.g., $/£(dollar per pound) and $/€ (dollar per Euro).

• Exhibit 1.2 provides selected currency exchange

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rate quotes.
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Exhibit 1.2 Selected Global Currency Exchange Rates for

January 2, 2018 (1 of 2)

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Exhibit 1.2 Selected Global Currency Exchange Rates for January 2, 2018 (2
of 2)

Note that a number of different currencies use the same symbol (for example both China and Japan have
traditionally used the ¥ symbol, which means “round” or “circle,” for yen and yuan respectively. All quotes
are mid-rates, and are drawn from the Financial Times.
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Exhibit 1.2 Selected Global Currency Exchange Rates for

Exchange
January 2, 2018 (1 of 2) 1 2 3
rates
quoted
against few
major
currencies

1) MYR4.0195=USD1.00 or abbreviated as RM4.0195/$;

2) MYR4.8415=EUR1.00 or RM4.8415/€;
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3) MYR5.4583=GBP1.00 or RM5.4583/£
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Financial • Risks must be explored, considered, and managed

• International monetary system is under constant scrutiny
Globalization • Large fiscal deficits resulting in the use of negative
and Risk interest rates
• Exchange rates are constantly in flux (fluctuation)
• Ownership and governance vary dramatically across the
world, particularly for the privately held or family-owned
business
• Global capital markets have become less
open and accessible
• Increasingly complicating financial management 12
with capital flows
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Eurocurrencies and Eurocurrency Interest Rates

(1 of 2)

• Eurocurrencies (a major linkage in the global and capital

markets)
• These are domestic currencies of one country on deposit in
a second country
• The Eurocurrency markets serve two valuable purposes:
• Eurocurrency deposits are an efficient and convenient
money market device for holding excess corporate
liquidity
• A major source of short-term bank loans to finance
corporate working capital needs (including export and
import financing)
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Eurocurrencies and Eurocurrency Interest Rates

(2 of 2)

• The eurocurrency market is relatively free from governmental

regulation and interference.
• Interest rate is referred to as the LIBOR - The London
Interbank Offered Rate.
• Often times a low spread exists with deposit and loan rates.
• Used widely as accepted rate of interest in standardized
quotations, loan agreements, and financial derivatives
transactions

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The Theory of Comparative Advantage (1 of 7)

• The theory of comparative advantage provides a

basis for explaining and justifying international trade in a
model world with the assumptions:
• free trade;
• perfect competition;
• no uncertainty;
• costless information; and
• no government interference.

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The Theory of Comparative Advantage (2 of 7)

• The theory contains the following features:
• Exporters in Country A sell goods or services to
unrelated importers in Country B
• Firms in Country A specialize in making products that
can be produced relatively efficiently, given Country A’s
endowment of factors of production, that is, land, labor,
capital, and technology
• Firms in Country B do likewise, given the factors of
production found in Country B
• In this way the total combined output of A and B is
maximized
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The Theory of Comparative Advantage (3 of 7)

• Because the factors of production cannot be moved freely
from Country A to Country B, the benefits of specialization
are realized through international trade
• The way the benefits of the extra production are shared
depends on the terms of trade, the ratio at which quantities
of the physical goods are traded
• Each country’s share is determined by supply and demand
in perfectly competitive markets in the two countries
• Neither Country A nor Country B is worse off than before
trade, and typically both are better off, albeit perhaps
unequally
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The Theory of Comparative Advantage (4 of 7)

• Although international trade might have approached the
comparative advantage model during the nineteenth century,
it certainly does not today, for the following reasons:
• Countries do not appear to specialize only in those
products that could be most efficiently produced by that
country’s particular factors of production (as a result of
government interference: tariffs, quotas etc.)
• At least two factors of production – capital and technology
– now flow directly and easily between countries, and even
labor.

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The Theory of Comparative Advantage (5 of 7)

• Modern factors of production are more numerous than
in this simple model
• Although the terms of trade are ultimately determined
by supply and demand
• Comparative advantage shifts over time, as less
developed countries become developed and realize
their latent opportunities
• The classical model of comparative advantage did not
account for other issues, such as the effect of
uncertainty and information costs, the role of
differentiated products in imperfectly competitive
markets, and economies of scale
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The Theory of Comparative Advantage (6 of 7)

• Comparative advantage is however still a relevant theory

to explain why particular countries are most suitable for
exports of goods and services that support the global
supply chain of both MNEs and domestic firms.
• The comparative advantage of the 21st century, however,
is one based more on services, and their cross-border
facilitation by telecommunications and the Internet.
• The source of a nation’s comparative advantage is still
created from the mixture of its own labor skills, access to
capital, and technology.

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The Theory of Comparative Advantage (7 of 7)

• Many locations for supply chain outsourcing exist today.

• It takes a relative advantage in costs, not just an absolute
advantage, to create comparative advantage.
• Clearly, the extent of global outsourcing is reaching out to
every corner of the globe.

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Exhibit 1.3 What Is Different About International Financial Management?

Concept International Domestic
Culture, history, and Each foreign country is unique and not always Each country has a known base case
institutions understood by MNE management
Corporate governance Foreign countries’ regulations and Regulations and institutions are well
institutional practices are all uniquely known
different
Foreign exchange risk MNEs face foreign exchange risks due to their Foreign exchange risks from
subsidiaries, as well as import/export and import/export and foreign competition
foreign competitors (no subsidiaries)
Political risk MNEs face political risk because of their Negligible political risks
foreign subsidiaries and high profile
Modification of domestic MNEs must modify finance theories like Traditional financial theory applies
finance theories capital budgeting and the cost of capital
because of foreign complexities
Modification of domestic MNEs utilize modified financial instruments Limited use of financial instruments and
financial instruments such as options, forwards, swaps, and letters derivatives because of few foreign
of credit exchange and political risks 22
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Market Imperfections: A Rationale for the Existence of the

Multinational Firm (1 of 2)

• MNEs strive to take advantage of imperfections in

national markets for products, factors of production, and
financial assets.
• Imperfections in the market for products translate into
market opportunities for MNEs.
• Large international firms are better able to exploit such
competitive factors as economies of scale, managerial
and technological expertise, product differentiation, and
financial strength than their local competitors.

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Market Imperfections: A Rationale for the Existence of the

Multinational Firm (2 of 2)
• Strategic motives drive the decision to invest abroad and
become a MNE and can be summarized under the following
categories:
• Market seekers
• Raw material seekers
• Production efficiency seekers
• Knowledge seekers
• Political safety seekers
• These categories are not mutually exclusive
• Often thrive best in oligopolistic competition.

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Exhibit 1.4 Aidan Corp: Initiation of the Globalization

Process Global Transition
Phase I: Example:
Aidan is a young firm
that manufactures and
distributes an array of
telecommunication
equipment
Aidan sells its
products in euros to
Irish customers and
buys its manufacturing
and service inputs
from Irish suppliers,
paying euros

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Exhibit 1.5 Aidan’s Foreign Direct Investment Sequence

Global Transition
Phase II:
If Aidan is successful
in its international
trade activities, they
will need to establish
foreign sales and
service affiliates.
Aidan’s continued
globalization will
require it to expand
its intellectual capital
and physical presence
globally. A variety of
strategic alternatives
are available to Aidan.
Foreign direct
investment is one
alternative. 26
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Exhibit 1.6 Selected Consolidated Income Results for Aidan

(Ireland) As an Ireland-based multinational company, Aidan must consolidate the financial
results (in this case, sales and earnings from the income statements) of foreign
subsidiaries. This requires converting foreign currency values into euros.

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Exhibit 1.6 Selected Consolidated Income Results for Aidan

(Ireland) Aidan will create more
and more foreign
Aidan, for the year shown, generated 61.3% of its subsidiaries as it
global sales in Ireland, with those sales making up expands globally
58.9% of its consolidated profits. From quarter to Each subsidiary will
quarter and year to year, both the financial have its own set of
performance of the individual subsidiaries will financial statements,
change in addition to exchange rates. typically denominated
* This is a simplified consolidation. Actual in a foreign currency
consolidation accounting practices require a
number of specific line item adjustments not shown The company must
here. periodically
consolidate all those
financial results and
report them in the
currency of its home
country 28