CHAPTER 1: INTRODUCTION
1
CHAPTER 1
INTRODUCTION
Chapter 1 emphasizes the internationalization of business and economic activity that has occurred since
the end of World War II. Although international business activities have existed for centuries, primarily in
the form of exporting and importing, only in the postwar period have multinational firms become
preeminent. The distinguishing characteristic of the MNC is its emphasis on global, rather than affiliate,
performance. Specifically, MNCs ask, “Where in the world should we build our plants, sell our products,
raise capital, and hire personnel?” Thus the true MNC is characterized more by attitude than the physical
reality of an integrated, global system of marketing and production activities. It involves looking beyond
the boundaries of the home country and treating the world as “our oyster.”
After stimulating student interest with this vision of the MNC, I then introduce the financial decisions
that MNCs must make. I begin by discussing the key concepts and lessons from domestic finance that
apply directly to international corporate finance. The lessons include the emphasis on cash flow rather
than accounting earnings, the time value of money, the importance of taxes, and the unwillingness of
investors to reward companies for activities (like corporate diversification) that investors could replicate
for themselves at no greater cost.
The key concepts, which I point out will arise time and again in the course, are arbitrage, market
efficiency, and the separation of risk into systematic risk, which must be rewarded, and unsystematic risk,
which is not rewarded. The latter concept, of course, is the intuition underlying both the capital asset
pricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoretical
framework of domestic corporate finance provides a useful frame of reference, and understanding it is
essential before proceeding with the more complex aspects of international financial management. I
devote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise, the
astute student will see a conflict between the irrelevance of unsystematic risk and hedging activities.
I then outline the key decision areas in international financial management: foreign exchange risk
management, managing working capital and the internal financial system, financing foreign units, capital
budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial
executives must cope with, including multiple currencies, rates of inflation, tax systems, and capital
markets, as well as foreign exchange and political risks.
INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
2
SUGGESTED ANSWERS TO “THE DEBATE OVER OUTSOURCING”
1. What are the pros and cons of outsourcing?
ANSWER. PROS: Outsourcing enables Americans to buy services less expensively abroad, increases U.S.
productivity, and enables U.S. companies to cut their costs while improving quality, time to market, and
2. How does outsourcing affect U.S. consumers? U.S. producers?
ANSWER. As the answer to part a) points out, outsourcing allows companies to buy services less
3. Longer term, what is the likely impact of outsourcing on American jobs?
4. Several states are contemplating legislation that would ban the outsourcing of government work
to foreign firms. What would be the likely consequences of such legislation?
SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS
1. Explain how globalization may affect even a small business in your local area.
ANSWER. Globalization entails opening national borders to enable freer movement of goods and services.
Due to the rapid decrease in communication and transportation costs over the last few decades, many
CHAPTER 1: INTRODUCTION
3
2. Opponents of globalization and outsourcing argue that locating manufacturing activities
abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather than
resulting in a net loss of jobs, employment has actually increased. Also, the average wages of
workers have increased. How would you account for this discrepancy between what the critics
say and what statistics reveal?
ANSWER. Globalization is a two-way street. While some U.S. firms locate their plants overseas, several
foreign companies have also invested in the U.S. economy and located their plants here. For example,
3. Elaborate on the benefits of a proactive approach to globalization and global competition.
ANSWER. Rather than react to globalization, firms benefit by facing globalization and global competition
head on. Globalization and global competition unleash the forces of creative destruction, whereby new
4. What are the various reasons for the emergence of multinational firms?
ANSWER. The primary reason for the emergence of MNCs is the international mobility of several factors
of production. MNCs emerge to take advantage of globally available raw materials, markets, specialized
5. Given the added political and economic risks that appear to exist overseas, are MNCs more or
less risky than purely domestic firms in the same industry? Consider whether a firm that
decides not to operate abroad is insulated from the effects of economic events that occur outside
the home country.
ANSWER. Individual foreign projects may face more political and economic risks than comparable
domestic projects. Yet MNCs are likely to be less risky than purely domestic firms because much of the
6. How is the nature of IBM’s competitive advantages related to its becoming an MNC?
7. If capital markets were perfect, i.e., capital could move freely across national borders, would
MNCs still exist? Why? Or, why not?
ANSWER. Even if capital moved freely across national borders, MNCs would still exist, because MNCs
CHAPTER 1: INTRODUCTION
5
8. What are the various ways in which domestic firms enter international markets? What are the
benefits and risks of each strategy of foreign market entry?
ANSWER. Three major ways in which domestic firms enter international markets are through exporting,
Entry
Benefits
Risks
Exporting
• Minimal capital requirements and start–up
costs
• Relatively low risk compared to other entry
strategies
Licensing
• Minimal investment requirements
• Cash flow is relatively low
Overseas
Production
• The firm can more easily stay abreast of
market developments, adapt its products and
• Tremendous capital and top management
commitment is required
9. Why do firms from each of the following categories become MNCs? Identify the competitive
advantages that a firm in each category must have to be a successful MNC.
a. Raw-materials seekers
b. Market seekers
c. Cost minimizers
ANSWER. FDI is most likely to be economically viable where the possibility of opportunism on the part
10. What factors help determine whether a firm will export its output, license foreign companies
to manufacture its products, or set up its own production or service facilities abroad? Identify
the competitive advantages that lead companies to prefer one mode of international expansion
over another.
ANSWER. Here are some factors involved in deciding how to enter a market:
i) PRODUCTION ECONOMIES OF SCALE. If these are important, then exporting might be appropriate.
11. Time Warner must decide whether to license foreign companies to produce its films and records
or set up foreign sales affiliates to sell its products. What factors might determine whether it
expands abroad via licensing or investing in its own sales force and distribution network?
ANSWER. Some of the factors that Warner should consider in determining whether it expands abroad via
licensing or by investing in its own sales force and distribution network are as follows:
ADDITIONAL CHAPTER 1 QUESTIONS AND ANSWERS
1.a. What are the various categories of MNCs?
1.b. What is the motivation for international expansion of firms within each category?
ANSWER. Raw materials seekers go abroad to exploit the raw materials that can be found there and can’t
2.a. How does foreign competition limit the prices domestic companies can charge and the wages
and benefits workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less-expensive goods
and services supplied by foreign producers. The likelihood of losing sales limits the prices domestic firms
2.b. What political solutions can help companies and unions avoid the limitations imposed by
foreign competition?
2.c. Who pays for these political solutions? Explain.
3.a. What factors appear to underlie the Asian currency crisis?
3.b. What lessons can we learn from the Asian currency crisis?
4.a. What is an efficient market?
4.b. What is the role of a financial executive in an efficient market?
ANSWER. In an efficient market, attempts to increase a firm’s value by purely financial measures or
5.a. What is the capital asset pricing model?
ANSWER. The CAPM quantifies the relevant risk of an investment and establishes the trade-off between
5.b. What is the basic message of the CAPM?
5.c. How might an MNC use the CAPM?
6. Why might total risk be relevant for a multinational corporation?
ANSWER. Higher total risk is relevant for an MNC because it could have a negative impact on the firm’s
7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the
government penalize U.S. firms that invest overseas rather than at home. According to Reich,
this kind of investment hurts exports and destroys well-paying jobs. Comment on this argument.
ANSWER. The assumption underlying Secretary Reich’s memo is inconsistent with the empirical
8.a. Are MNCs riskier than purely domestic firms?
8.b. What data would you need to address this question?
9. Is there any reason to believe that MNCs may be less risky than purely domestic firms?
Explain.
ANSWER. Yes. International diversification may actually enable firms to reduce their total risk. Much of
10. In what ways do financial markets grade government economic policies?
ANSWER. Traders and their customers receive a continuing flow of news from around the world. The
11. In seeking to predict tomorrow’s exchange rate, are you better off knowing today’s exchange
rate or the exchange rates for the past 100 days?
12. Why might setting up production facilities abroad lead to expanded sales in the local market?
13a. How might total risk affect a firm’s production costs and its ability to sell? Give some
examples of firms in financial distress that saw their sales drop.
ANSWER. Higher total risk can lead to lower sales and higher production costs. The inverse relation
13.b. What is the relation between the effects of total risk on a firm’s sales and costs and its desire
to hedge foreign exchange risk?
INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
12
SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS
1. In a satirical petition on behalf of French candlemakers, French economist Frederic Bastiat
called attention to cheap competition from afar: sunlight. A law requiring the shuttering of
windows during the day, he suggested, would benefit not only candlemakers but “everything
connected with lighting” and the country as a whole. He explained: “As long as you exclude, as
you do, iron, corn, foreign fabrics, in proportion as their prices approximate to zero, what
inconsistency it would be to admit the light of the sun, the price of which is already at zero
during the entire day!”
1.a. Is there a logical flaw in Bastiat’s satirical argument?
ANSWER. No. Bastiat is precisely right. The objective of trade is to gain access to goods and services at
1.b. Do Japanese automakers prefer a tariff or a quota on their U.S. auto exports? Why? Is there
likely to be consensus among the Japanese carmakers on this point? Might there be any
Japanese automakers that are likely to prefer U.S. trade restrictions? Why? Who are they?
ANSWER. It depends. Both tariffs and quotas will lead to higher prices to U.S. consumers of imported
Japanese cars. With tariffs, however, most of this price increase will go to the U.S. government in the
1.c. What characteristics of the U.S. auto industry have helped it gain protection? Why does
protectionism persist despite the obvious gains to society from free trade?
2. Review the arguments both pro and con on NAFTA. What is the empirical evidence so far?
ANSWER. NAFTA has helped increase international trade between the U.S., Mexico, and Canada. The
3. Given the resources available to them, countries A and B can produce the following
combinations of steel and corn.
Country A
Steel (tons)
Corn (bushels)
Steel (tons)
Corn (bushels)
36
0
54
0
6
15
9
45
0
18
0
54
3.a. Do you expect trade to take place between countries A and B? Why?
ANSWER. Yes. Given the data presented, if country A has 6 units of resources and it devotes X of these
3.b. Which country will export steel? Which will export corn? Explain.
ANSWER. Given these comparative advantages, A will export steel and B will export corn. The price of