MULTINATIONAL

FINANCIAL MANAGEMENT
 How is multinational financial
management different from financial
management as practiced by a firm
that has no direct contacts with
foreign firms or customers

What special problem and

challenges do multinational
firms face?

INFOGRAPHIC
OPTION

TINYPPT designed template

and background for
presentation in PowerPoint
The intrinsic value of a firm is determined by the size, timing,
and risk of its expected future free cash flows (FCF).This is true
for foreign as well as domestic operations, but the FCF of a
foreign operation is affected by exchange rates, cultural
differences, and the host country's regulatory environment. In
addition, global financial markets and political risk can affect
the cost of capital.
 firms that operate in
an integrated
fashion in a number
1
WHAT IS A of countries.
MULTINATIONAL
CORPORATION

2
1
MULTINATIONAL
FINANCIAL
MANAGEMENT
Companies “go
WHY DO global” for many
COMPANIES “GO reasons,
GLOBAL

2
COMPANIES “GO GLOBAL” FOR MANY REASONS 01 To broaden
their markets.

02 To seek
raw materials

03 To seek new
technology

To seek
04 production
efficiency
To avoid political
05 and regulatory
hurdles

06 To diversify
 Currencies Terrorism
1 5
Legal 9 and crime
systems

Cultures. Government
3 7 intervention

Major factors
that complicate
financial
management in
multinational
firms.

Political risk
4 Economic 8
systems
Languages Taxation
2 6
EXCHANGE RATE DETERMINATION
 MEASURING
EXCHANGE RATE MOVEMENTS
• An exchange rate measures the value of one currency in
units of another currency.
• When a currency declines in value, it is said to depreciate.
When it increases in value, it is said to appreciate.
• On the days when some currencies appreciate while others
depreciate against the dollar, the dollar is said to be “mixed
in trading.”
• The percentage change (% D) in the value of a
foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.

• A positive % D represents appreciation of

the foreign currency, while a negative % D
represents depreciation.
 FACTORS THAT INFLUENCE
EXCHANGE RATES
RELATIVE INFLATION RATES
Example :

$/£ U.S. inflation 

S1
Þ  U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1
Þ  British desire for U.S.
D0
goods, and hence the
Quantity of £
supply of £.
RELATIVE INTEREST RATES

Examples :

$/£
U.S. interest rates 
S0
Þ  U.S. demand for
r0
S1 British bank deposits,
and hence £.
r1 D0

D1
Þ  British desire for U.S.
Quantity of £
bank deposits, and
hence the supply of £.
…………………RELATIVE INTEREST RATES

• A relatively high interest rate may actually

reflect expectations of relatively high
inflation, which discourages foreign
investment.

• It is thus useful to consider real interest

rates, which adjust the nominal interest
rates for inflation.
………………….RELATIVE INTEREST RATES

• real nominal
interest  interest – inflation rate
rate rate

• This relationship is sometimes called the

Fisher effect.
RELATIVE INCOME LEVELS

Example

$/£
U.S. income level 
Þ  U.S. demand for
S0 ,S1

r1
British goods, and
r0 hence £.
D1
Þ No expected change for
D0
the supply of £.
Quantity of £
GOVERNMENT CONTROLS

• Governments may influence the equilibrium exchange rate by:

• imposing foreign exchange barriers,
• imposing foreign trade barriers,
• intervening in the foreign exchange market, and
• affecting macro variables such as inflation, interest rates, and income
levels.
EXPECTATIONS

• Foreign exchange markets react to any news that may have a future effect.
• Institutional investors often take currency positions based on anticipated
interest rate movements in various countries.
• Because of speculative transactions, foreign exchange rates can be very
volatile.
 HOW FACTORS HAVE INFLUENCED EXCHANGE
RATES

• Because the dollar’s value changes by different

magnitudes relative to each foreign currency,
analysts often measure the dollar’s strength with an
index.
• The weight assigned to each currency is determined
by its relative importance in international trade
and/or finance.
HOW FACTORS CAN AFFECT EXCHANGE
RATES
Trade-Related
Factors
1. Inflation Parent demand for foreign goods, i.e.
Differential demand for foreign currency
2. Income
Differential Foreign demand for parent firm.
3. Gov’t Trade goods, i.e. supply of foreign currency
Restrictions
Exchange rate
between foreign
currency and the
parent currency

Financial parent demand for foreign securities,

Factors i.e. demand for foreign currency
1. Interest Rate
Differential Foreign demand for parent firm.
securities, i.e. supply of foreign
2. Capital Flow currency
Restrictions
IMPACT OF EXCHANGE RATES ON AN MNC’S
VALUE

Inflation Rates, Interest Rates,

Income Levels, Government Controls,
Expectations

m 
n 
 
E CFj , t  E ER j , t  
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t )= expected cash flows in currency j to be
received by the parent at the end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to parent currency at the
end of period t
 IS EXCHANGE RATE RISK
RELEVANT?
PURCHASING POWER PARITY ARGUMENT

 Exchange rate movements will be matched by price

movements.
PPP does not necessarily hold.
THE INVESTOR HEDGE ARGUMENT

 MNC shareholders can hedge against exchange rate

fluctuations on their own.
 The investors may not have complete information on
corporate exposure. They may not have the capabilities to
correctly insulate their individual exposure too.
CURRENCY DIVERSIFICATION ARGUMENT

 An MNC that is well diversified should not be affected by

exchange rate movements because of offsetting effects.
 This is a naive presumption.
STAKEHOLDER DIVERSIFICATION ARGUMENT

 Well diversified stakeholders will be somewhat insulated

against losses experienced by an MNC due to exchange rate
risk.
 MNCs may be affected in the same way because of exchange
rate risk.
RESPONSE FROM MNCS

• Many MNCs have attempted to stabilize their earnings with

hedging strategies, which confirms the view that exchange
rate risk is relevant.
Measuring Exposure To
Exchange Rate Fluctuations

IS EXCHANGE RATE RISK RELEVANT?

PURCHASING POWER PARITY ARGUMENT

 Exchange rate movements will be matched by price
movements.
PPP does not necessarily hold.
 TYPES OF EXPOSURE

• Although exchange rates cannot be forecasted with perfect

accuracy, firms can at least measure their exposure to
exchange rate fluctuations.
• Exposure to exchange rate fluctuations comes in three
forms:
• Transaction exposure
• Economic exposure
• Translation exposure
 TRANSACTION
EXPOSURE
• The degree to which the value of future cash transactions can be
affected by exchange rate fluctuations is referred to as
transaction exposure.

• To measure transaction exposure:

 project the net amount of inflows or outflows in each foreign currency,
and
 determine the overall risk of exposure to those currencies.

• MNCs can usually anticipate foreign cash flows for an upcoming

short-term period with reasonable accuracy.
• After the consolidated net currency flows for the entire MNC has
been determined, each net flow is converted into either a point
estimate or a range of a chosen currency, so as to standardize the
exposure assessment for each currency.
• An MNC’s overall exposure can be assessed by considering each
currency position together with the currency’s variability and the
correlations among the currencies.
• The standard deviation statistic on historical data serves as one
measure of currency variability. Note that currency variability levels
may change over time.
 ECONOMIC EXPOSURE
• Economic exposure refers to the degree to which a firm’s present value
of future cash flows can be influenced by exchange rate fluctuations.
• Cash flows that do not require conversion of currencies do not reflect
transaction exposure. Yet, these cash flows may also be influenced
significantly by exchange rate movements.
• Even purely domestic firms may be affected by economic exposure if
there is foreign competition within the local markets.
• MNCs are likely to be much more exposed to exchange rate
fluctuations. The impact varies across MNCs according to their
individual operating characteristics and net currency positions.
• One measure of economic exposure involves classifying the firm’s cash
flows into income statement items, and then reviewing how the earnings
forecast in the income statement changes in response to alternative
exchange rate scenarios.
• In general, firms with more foreign costs than revenues will be
unfavorably affected by stronger foreign currencies.
• Another method of assessing a firm’s economic exposure involves
applying regression analysis to historical cash flow and exchange rate
data.
• The exposure of the MNC’s consolidated financial statements to
exchange rate fluctuations is known as translation exposure.
• In particular, subsidiary earnings translated into the reporting currency
on the consolidated income statement are subject to changing exchange
rates.
DOES TRANSLATION EXPOSURE MATTER?

• Cash Flow Perspective - Translating financial statements for

consolidated reporting purposes does not by itself affect an MNC’s
cash flows.
• However, a weak foreign currency today may result in a forecast of a
weak exchange rate at the time subsidiary earnings are actually
remitted.
• Stock Price Perspective - Since an MNC’s translation exposure affects
its consolidated earnings and many investors tend to use earnings
when valuing firms, the MNC’s valuation may be affected.
• IN GENERAL, TRANSLATION EXPOSURE IS RELEVANT BECAUSE
some MNC subsidiaries may want to remit their earnings to their
parents now,
the prevailing exchange rates may be used to forecast the
expected cash flows that will result from future remittances, and
consolidated earnings are used by many investors to value MNCs.

• AN MNC’S DEGREE OF TRANSLATION EXPOSURE IS DEPENDENT ON:

the proportion of its business conducted by its foreign
subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.