Chapter #1

1. Multinational Corporation:
MNC is the company which has at least one subsidiary other than the home country. Home
country is the country where the multinational headquarter is located. Host country is the
country where the multinational subsidiary is located.
So, we can say, MNC is a corporation or enterprise that conducts and controls productive
activities in more than one country.
2. Goals of MNC:
The main goals of MNC are
1) Profit maximization: The main motive of MNC is to maximize profit. Profit
maximization means maximizing the dollar earnings. Profit can be maximized by reducing
the cost by introducing JIT, TQM, process reengineering and by economies of scale.
2) Wealth maximization: Another main motive of MNC is to maximize wealth. Wealth
maximization means maximization of the price of the shares. The share price can be
maximized by making good investment decisions, good fund raising decision and good
dividend decision.
3. How can we reduce cost?
We can reduce cost by following the way
1) Introducing Just-in-Time (JIT): In the JIT system material is procured when it is
needed. Raw material cost and finished goods inventory cost is reduced by JIT system. As
inventory is the part of total cost, so if inventory cost is reduced then profit will be maximum
form previous year.
2) Total Quality Management (TQM): Cost can be reduced if total quality is ensured. TQM
implies that supervision/ monitoring should be extensive in the process of production, so
internal failure cost and external failure cost will be the minimum. The cost which is
associated with the rework of defectives, spoilage is termed as the internal failure cost. And
the cost which is associated for rework of after sales is termed as external failure cost.
3) Process reengineering: It tells us that unnecessary process should be discarded from the
process by which we can reduce cost.
4) By economies of scale: If we take advantage of large scale production then conditionally
per unit variable cost will also be variable.
4. How can we maximize the share price?
We can maximize the share price
1) By making good investment decisions: We can maximize the share price by making
good and effective investment decisions.
2) By making good fund raising decision: Fund can be raised by taking appropriate capital
structure decision. Cost of capital structure can be reduced by appropriate capital mixing, i.e.
equity, preference share, debt capital, retained earnings.

3) By making good dividend decision: A financial manager decides closely how much of
the current income to pay out as dividends as different to how much to retain and reinvestthat is called the dividend policy decision. The optimal dividend strategy is the one that
maximizes the firm's stock price.
5. Why the achievement of goal of MNC is difficult to domestic firm/company?
The achievement of goals of MNC is difficult to domestic firm for the following reason:
1) Monitoring is more difficult: It is more difficult to monitor the host countrys branches
by the head office which is located in parent country. But in domestic firm it is so much easy
to monitor regularly all the branches because all are established in the one country. As a
result, achievement of goals of MNC is difficult to domestic firms. MNCs subsidiaries
scattered around the world may experience larger agency problem because monitory
managers of distant managers of distant subsidiaries in foreign countries is mere difficult.
2) Different cultures: Different culture, different languages with employee and management
are also an obstacle to achieve its goal than the domestic firm where the management and
employee culture are almost similar. Foreign subsidiary managers raised in different culture
may not follow uniform goals.
3) Size of the MNC: The size of the domestic firm is small, so it is easy for management to
manage everything than the MNC where the size is too large.
4) Tend to down pay: Employees of subsidiary want to pay minimum and owner wants high
which creates difficulties to achieve its goals in MNC than domestic firm.
6. Agency Problem of MNCs:
The agency problem reflects a conflict of interests between decision-making managers and
the owners of the MNC. Managers of an MNC may make decisions that conflict with the
firms goal to maximize shareholder wealth. For example, a decision to establish a subsidiary
in one location versus another may be based on the locations appeal to a particular manager
rather than on its potential benefits to shareholders. A decision to expand a subsidiary may be
motivated by a managers desire to receive more compensation rather than to enhance the
value of the MNC. This conflict of goals between a firms managers and shareholders is often
referred to as the agency problem. The cost of ensuring that managers maximize shareholder
wealth is referred to as agency costs.
7. Why might agency costs be larger for an MNC than for a purely domestic firm?
The cost of ensuring that managers maximize shareholder wealth is referred to as agency
costs. The agency costs are normally larger for MNCs than purely domestic firms for the
following reasons:
First, MNCs with subsidiaries scattered around the world may experience larger agency
problems because monitoring managers of distant subsidiaries in foreign countries is more
difficult. Second, foreign subsidiary managers raised in different cultures may not follow
uniform goals. Third, the sheer size of the larger MNCs would also create large agency
problems.
8. How can reduce agency problems?
Agency problems can be reduced by the following way:

1) Impact of managerial control:

This view can be viewed from two perspectives:
a) Centralized Multinational Financial Management: A centralized management style can
reduce agency cost because it allows managers of the parent to control foreign subsidiaries
and therefore reduces the power of subsidiary managers. However, the parent managers may
make poor decisions for the subsidiary if they are not as informed as subsidiary managers
about financial characteristics of the subsidiary.
b) Decentralized Multinational Financial Management: The alternative style of
organizing an MNCs management is decentralized management style. This style is more
likely to result in higher agency cost because subsidiary managers make decision that does
not focus on maximizing the value of the entire MNC. Yet this style gives more control to
their managers who are closer to the subsidiarys operations and environment. To the extent
that subsidiary managers recognize the goal of maximizing the value of the overall MNC and
are compensated in accordance with that goal, the decentralized management style may be
more effective.
The figure of centralized and decentralized Financial Management is as follows:

2) Impact of Corporate Control:

An MNC is subject to various forms of corporate control that can be used to reduce agency
problem:

a) Stock option: An MNC may partially compensate its board members and its executives
with its stock, which can encourage them to make decisions that maximize the MNCs stock
price. However, this strategy may effectively control only decisions by managers and board
members who receive stock as compensation. In addition, some managers may still make
decisions that conflict with the MNCs goal if they do not expect their decisions to have
much of an impact on the stock price.
b) Hostile takeover threat: A second form of corporate control is the threat of a hostile
takeover if the MNC is inefficiently managed. In theory, this threat is supposed to encourage
managers to make decisions that MNCs value, since stock price to decline. Another firm
might then acquire the MNC at a low price and terminate the existing managers.
c) Investor monitoring: A third form of corporate control is monitoring by large
shareholders. Their monitoring tends to focus on board issues to ensure that MNC uses a
compensation system that motivates managers or board members to make decision to
maximize the MNCs value, to use excess cash for repurchasing shares or stock rather than
investing in questionable project; and to ensure that the MNC does not insulate itself from the
threat of takeover (by implementing anti-taken over amendments).
d) Incentives: It is a form of corporate control which says that if the lucrative incentives are
offered to the managers of the MNCs, they will be motivated and by this, agency problems
can be reduced.
e) Punishment or fire the management: The management may be punished or fired from
their job to reduce the agency problem.
9. Describe the constraints which interfering the MNCs goal.
The constraints faced by financial managers attempting to maximize shareholder wealth are:
1) Environmental Constrains: Each country enforces its own environmental constrains.
Some countries may enforce more of these restrictions on a subsidiary whose parent is based
in a different country. Building codes, disposal of production waste materials, and pollution
controls are examples of restrictions that force subsidiaries to incur additional costs.
2) Regulatory Constrains: Each country also enforces its own regulatory constrains
pertaining to taxes. Currency convertibility rules, earnings remittance restrictions, and other
regulations that can affect cash flows of a subsidiary established there.
3) Ethical Constrains: There is no census standard of business conduct that applies to all
countries. A business practice that is perceived to be unethical in one country may be totally
ethical in another. For example Bribes, Sexual product in Arab countries.
10. Valuation Model for an MNC:
The value of an MNC is relevant to its shareholders and its debt holders. When managers
make decisions that maximize the value of the firm, they maximize shareholder wealth. The
valuation model of an MNC shows that the MNC valuation is favorably affected when its
foreign cash inflows increase, the currencies denominating those cash inflows increase, or the
MNCs required rate of return decreases.
Domestic Model:
The value of the firm should be present value of expected cash flows, i.e.
Valuing international cash flows:

E(CF$t) = [E(CFj.t.) X E(Erj.t. )]

Where:
E(CF$t) = The amount of cash flow denominated in domestic currency;
E(CFj.t.) = The amount of cash flow denominated in foreign currency;
E(Erj.t. )= The expected currency conversion rate.
Example:
Carolina Co. has expected cash flows of $100,000 from local business and 1 million Mexican
pesos from business in Mexico at the end of period t. Assuming that the pesos value is
expected to be $.09, the expected dollar cash flows are:
E(CF$t) = [E(CFj.t.) X E(Erj.t. )]
= ($100,000) + [1,000,000 pesos ($.09)]
= ($100,000) + ($90,000)
= $190,000
The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars
and therefore did not have to be converted.
11. International business:
International business means the flow of funds between two or more regions, countries and
nations beyond their political boundary. It is a specific entity, such as a multinational
corporation or international business company that engages in business among multiple
countries.
12. Why international trade is necessary/ theories of international business?
The commonly held theories as to why firms become motivated to expand their business
internationally are:
i) Theory of comparative advantages: Countries specialize in the production of goods; they
can produce with relative efficiency and trade for other products.
ii) Theory of imperfect markets: Factors of production (labor and other resources) are
immobile.
iii) Theory of product cycle: Firm introduces product in home market, then exports it, then
establish a subsidiary, and then differentiate the product.
These theories are broadly discussed below:
i) Theory of comparative advantage:
Multinational business has generally increased over time. Part of this growth is due to the
heightened realization that specialization by countries can increase production efficiency.
When a country specializes in some products, it may not produce other products, so trade
between countries is essential. This is the argument made by the classical theory of
comparative advantage. Comparative advantages allow firms to penetrate foreign markets.
Examples: Some countries, such as Japan and the United States, have a technology
advantage, while other countries, such as Jamaica, Mexico, and South Korea, have an
advantage in the cost of basic labor. Since these advantages cannot be easily transported,
countries tend to use their advantages to specialize in the production of goods that can be
produced with relative efficiency. This explains why countries such as Japan and the United
States are large producers of computer components, while countries such as Jamaica and
Mexico are large producers of agricultural and handmade goods.

ii) Imperfect market theory:

Countries differ with respect to resources available for the production of goods. The real
world suffers from imperfect market conditions where factors of production are somewhat
immobile. There are costs and often restrictions related to the transfer of labor and other
resources used for production. There may also be restrictions on transferring funds and other
resources among countries. Because markets for the various resources used in production are
imperfect, MNCs such as the Gap and Nike often capitalize on a foreign countrys
resources. Imperfect markets provide an incentive for firms to seek out foreign opportunities.
3) Product cycle theory:
One of the more popular explanation as to why firms evolve into MNCs is introduced in the
product cycle theory. This theory suggests that, as a firm matures, it may recognize additional
opportunities outside its home country. Whether the foreign business diminishes or expands
over time will depend on how successful is at maintaining some advantage over its
competition. The advantage could represent an edge in its production or financing approach
that reduces cost or an edge in its marketing approach that generates and maintains a strong
demand for its product.
13. International Business Methods:
Firms use several methods to conduct international business. The most common methods are:
1) International trade:
International trade is a relatively conservative approach that can be used by firms to penetrate
markets (by exporting) or to obtain supplies at a low cost (by importing). This approach
entails minimal risk because the firm does not place any of its capital at risk.
2) Licensing:
Licensing obligates a firm to provide its technology (copyrights, patents, trademarks, or trade
names) in exchange for fees or some other specified benefits. Licensing allows firms to use
their technology in foreign markets without a major investment in foreign countries and
without the transportation costs that result from exporting. For example: Springs, Inc. has
set up a licensing agreement with a manufacturer in the Czech Republic. When springs
receive orders for its products from customers in Eastern Europe, it relies on this
manufacturer to produce and deliver the products ordered. This expedites the delivery process
and may even allow springs to have the products manufactured at a lower cost than if it
produced them itself.
3) Franchising:
Franchising obligates a firm to provide specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange for periodic fees.
Like licensing, franchising allows firms to penetrate foreign markets without a major
investment in foreign countries. For example: McDonalds, Pizza Hut, Subway Sandwiches,
Blockbuster Video, and Dairy Queen have franchises that are owned and managed by local
residents in many foreign countries.
4) Joint ventures:
A joint venture is a venture that is jointly owned and operated by two or more firms. Many
firms penetrate foreign markets by engaging in a joint venture with firms that reside in those
markets. Most joint ventures allow two firms to apply their respective comparative

advantages in a given project. For example: General Mills, Inc., joined in a venture with
Nestl SA, so that the cereals produced by General Mills could be sold through the overseas
sales distribution network established by Nestl.
5) Acquisitions of existing operations:
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign
markets. Acquisitions allow firms to have full control over their foreign businesses and to
quickly obtain a large portion of foreign market share. An acquisition of an existing
corporation is subject to the risk of large losses, however, because of the large investment
required. In addition, if the foreign operations perform poorly, it may be difficult to sell the
operations at a reasonable price. For example: American Express recently acquired offices in
London, while Airtel purchased Warid company.
6) Establishing new foreign subsidiaries:
Firms can also penetrate foreign markets by establishing new operations in foreign countries
to produce and sell their products. Like a foreign acquisition, this method requires a large
investment. Establishing new subsidiaries may be preferred to foreign acquisitions because
the operations can be tailored exactly to the firms needs. However, the firm will not reap any
rewards from the investment until the subsidiary is built and a customer base established.
14. Explain why political risk may discourage international business?
Political risk refers to the risk that a host country will make political decisions that will prove
to have an adverse effect on multinationals profit and goals. Basically political risk increases
the rate of return required to invest in foreign projects. Some foreign projects would have
been feasible if there was no political risk, but will not be feasible because of political risk.
Political risk (also called country risk) in any country can affect the level of an MNCs sales.
A foreign government may increase taxes or impose barriers on the MNCs subsidiary.
Alternatively, consumers in a foreign country may boycott the MNC if there is friction
between the government of their country and the MNCs home country.
15. Explain how the theory of comparative advantage relates to the need for
international business.
The theory of comparative advantage implies that countries should specialize in production,
thereby relying on other countries for some products. Consequently, there is a need for
international business.
16. Explain how the product cycle theory relates to the growth of an MNC.
The product cycle theory suggests that at some point in time, the firm will attempt to
capitalize on its perceived advantages in markets other than where it was initially established.
17. Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous
opportunities for international expansion.
Coca Cola and PepsiCo still have new international opportunities because countries are at
various stages of development. Some countries have just recently opened their borders to
MNCs. Many of these countries do not offer sufficient food or drink products to their
consumers.