Foundations of Financial Management: An Analysis (Part 81)

It’s good to have money and the things that money can buy, but it’s good, too, to check up once in a while and make sure that you haven’t lost the things that money can’t buy. 

George Lorimer

International Financial Management

(Part A)

by

Charles Lamson

Today the world economy is more integrated than ever, and nations are dependent on one another for many valuable and scarce resources. This growing interdependence necessitates the development of sound international business relations, which will enhance the prospects for future international cooperation and understanding. It is virtually impossible for any country to isolate itself from the impact of international developments in an integrated world economy. 

The capital markets are integrated and world events such as a currency crisis, government defaults on sovereign debt, terrorism, or the COVID 19 crisis can cause stock and bond markets to suffer emotional declines.

Even when stock and bond markets are relatively stable and free of crisis, companies will have to pay attention to the currency markets. These currency markets impact imports and exports between countries and therefore affect sales and earnings of all international companies. 

The next few posts deal with the dimensions of doing business worldwide. Here, we will provide a basis for understanding the complexities of international financial decisions. Such an understanding is important for anyone involved in international transactions.

The following section describes the international business firm and its environment. Then, in the last few posts of this analysis we examine foreign exchange rates and the variables influencing foreign currency values and strategies for dealing with foreign exchange risk. Finally, we discuss international financing sources, including the Eurodollar market, the Eurobond market, and foreign equity markets.

The Multinational Corporation: Nature and Environment

The focus of international financial management has been the multinational corporation (MNC). One might ask, just what is a multinational corporation? Some definitions of a multinational corporation require that a minimum percentage (often 30% or more) of a firm's business activities be carried on outside its national borders. For our understanding, however, a firm doing business across its national borders is considered a multinational enterprise. Multinational corporations can take several forms. Four are briefly examined.

Exporter An MNC could produce a product domestically and export some of that production to one or more foreign markets. This is, perhaps, the least risky method---reaping the benefits of foreign demand without committing any long-term investment to that foreign country.

Licensing Agreement A firm with exporting operations may get into trouble when a foreign government imposes or substantially raises an import to the level at which the exporter cannot compete effectively with the local domestic manufacturers. The foreign government may even ban all imports at times. When this happens the exporting firm may grant a license to an independent local producer to use the firm's technology in return for a license fee or a royalty. In essence, then, the MNC will be exporting technology, rather than the product, to that foreign country.

Joint Venture As an alternative to licensing, the MNC may establish a joint venture with a local foreign manufacturer. The legal, political, and economic environments around the globe are more conducive to the joint venture arrangement than any of the other modes of operation. Historical evidence also suggests that a joint venture with a local entrepreneur exposes the firm to the least amount of political risk. This position is preferred by most business firms and by foreign governments as well.

Fully Owned Foreign Subsidiary Although the joint venture form is desirable for many reasons, it may be hard to find a willing and cooperative local entrepreneur with sufficient capital to participate. Under these conditions the MNC may have to go it alone. For political reasons, however, a wholly-owned foreign subsidiary is becoming more of a rarity. The reader must keep in mind that whenever we mention a foreign affiliate in the ensuing discussion, it could be a joint venture or a fully owned subsidiary.

As the firm crosses its national borders, it faces an environment that is riskier and more complex than its domestic surroundings. Sometimes the social and political environment can be hostile. Despite these difficult changes, foreign affiliates often are more profitable than domestic businesses. A purely domestic firm faces several basic risks, such as the risk related to maintaining sales and market share, the financial risk of too much leverage, the risk of a poor equity market, and so on. In addition to these types of risks, the foreign affiliate is exposed to foreign exchange risk and political risk. While the foreign affiliate experiences a larger amount of risk than a domestic firm, it actually lowers the portfolio risk of its parent corporation by stabilizing the combined operating cash flows for the MNC. This risk reduction occurs because foreign and domestic economies are less than perfectly correlated.

Foreign business operations are more complex because the host country's economy may be different from the domestic economy. The rate of inflation in many foreign countries is likely to be higher than in the United States. The rules of taxation are different. The structure and operation of financial markets and institutions also vary from country to country, as do financial policies and practices. The presence of a foreign affiliate benefits the host country's economy. Foreign affiliates have been a decisive factor in shaping the pattern of trade, investment, and the flow of technology between nations. They can have a significant positive impact on a host country's economic growth, employment, trade, and balance of payments. This positive contribution, however, is occasionally overshadowed by allegations of wrongdoing. For example, some host countries have charged that foreign affiliates subverted their governments and caused instability of their currencies. The less-developed countries (LDCs) have, at times, alleged that foreign businesses exploit their labor with low wages.

The multinational companies are also under constant criticism in their home countries where labor unions charge the MNCs with exporting jobs, capital and technology to foreign nations while avoiding their fair share of taxes. Despite all these criticisms, multinational companies have managed to survive and prosper. The MNC is well positioned to take advantage of imperfections in the global markets. Furthermore, since current global resource distribution favors the MNC's survival and growth, it may be concluded that the multinational corporation is here to stay.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 603-607*

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