International Financial Management
Technological advances have made the world a much smaller place. Globalization is happening rapidly and more and more countries are entering the global market. The world economy is more integrated than ever before and nations are dependent on one another for valuable and scare resources. This interdependence has resulted in the need for sound international business relations, as it is virtually impossible for any country to isolate itself from the impact of international developments in an integrated world economy. Wars, natural disasters, currency crisis, political unrest and infectious disease, just to name a few, can have an short term impact on local economies but can also have catastrophic effects on specific industries in other countries that are dependent on a specific export. With financial markets becoming more global, a major impact in one area of the world can affect economies that are thousands of miles away. To learn a little bit about globalization, visit the short video below on YouTube.
The Multinational Corporation
The main focus of international financial management has been multinational corporations. For any of us who have traveled overseas and come into contact with products from home such as Pepsi or Coca-cola in foreign markets, these are multinational corporations. A multinational corporation by definition is is corporations whose business across national borders exceeds the minimum percentage, which is usually 30%. These corporations can take many forms. Four of the forms they can take is exporter, licensing agreement, joint venture or fully owned foreign subsidiary.
Exporter- The least riskiest method of a MNC is that of exporter. An MNC can produce their products domestically and then export them to foreign markets. It is the least risky because the corporation can reap the rewards of revenue in foreign markets without having to commit to a long-term investment in those markets.
Licensing Agreement- If the market where a firm is exporting to begins to impose high tariffs on imports or even ban imports for a time, the firm can grant a license to an independent local producer to use the firms technology in return for a license fee or a royalty. This way the firm will still be able to export but instead of exporting a product they would be exporting technology.
Joint Venture- Instead of a licensing agreement, a firm can choose to go into a joint partnership with a local foreign manufacturer. Going into business with a local company can make it much easier for a firm to establish a market there. The local company would be familiar with the culture, politics and can make it much easier to establish permits and anything else a business might need to thrive. They can make it much easier to cut through any red tape or local barriers in place. Joint ventures are most preferred by both global businesses and foreign governments. For firms, what better way to learn about to the local culture than by having a partnership with locals who know everything there is to know about the place. Locals might also trust a local business a lot quicker than a foreign one.
Fully Owned Foreign Subsidiary- Although a joint venture is more desirable, sometimes it is hard to find a willing and cooperative local business with the capital to participate. For these reasons sometimes business must enter foreign markets alone. This means a lot more work for the business. They have to figure out the local economic climate, whether there is a need in that market for their product or service and how to establish themselves there. For political reasons, a fully owned foreign subsidiary is becoming a rarity. Domestic firms face basic risks, such as maintaining sales and market shares. In addition to these risks, foreign firms also face political risk and foreign exchange risks. The foreign economy may be different than the domestic economy. The rate of inflation can be higher in a foreign country and the rules of taxation can be very different. Companies also have to consider cultural differences. In India, for example, cows are considered sacred and are not consumed. If a MNC such as McDonald's wants to operate there, they would have to change their menu accordingly to not include beef. Offending the local culture is a sure way to fail.
Foreign Exchange Rate
Many countries have different types of currency. The United States has the dollar, which many countries have adopted. In Ecuador, for example, where I am from, the dollar is used. They used to use Sucre's but they made the decision to adapt to the U.S. dollar instead after they experienced the worst economic crisis in decades. The relationship between the values of two currencies is known as the exchange rate. There is no guarantee that any currency will stay strong relative to other currencies. This includes the dollar. High budget deficiencies and unsustainable policies are some of the factors that can affect currency worth in the foreign market. There are many factors that affect currency rates. Some of the factors are inflation, interest rates, balance of payments and government policies.
International transactions involve more than one currency, making it much riskier than domestic exchanges. Since most foreign currency values fluctuate from time to time, the monetary value of a transaction can be measured in either the seller's currency or the buyer's currency. This can result in the seller receiving less revenue than they were expecting or the buyer having to spend more money than they anticipated. This is where the term foreign exchange risk comes into play. Anyone involved in international trade can be affected by this risk. Although entering the foreign market can be very profitable for a business, there are high risks as well that need to be taken into consideration.
Foreign exchange gains and losses from international transactions reflect transaction exposure on the income statement. As a consequence of these gains and losses, the volatility of reported earnings per share increases. There are three different strategies that can be used to minimize this exposure and they are hedging in the forward exchange market, hedging in the money market and hedging in the currency futures market. For more information on these strategies you can visit Forwards, Futures and Money Market Hedging.
Foreign Investment Decisions
Firms have many decisions to make when considering whether or not to enter the global market. The Directory of American Firms Operating in Foreign Countries estimates that more than 4,300 U.S. firms have one or more stakes in the foreign market. There are several reasons why local companies choose to enter the global market. Cheaper production cost and labor are at the top of that list. Companies can make their products a lot cheaper in a foreign markets and also avoid import tariffs in those countries. Many companies have no choice in entering the foreign market if their competitor does. This is why if you see Coca-cola in a foreign market you are very likely to see Pepsi as well. Same goes for fast food chains such as McDonald's and Burger King. Many countries also offer tax incentives to foreign firms as well. The prospect of cheap production, labor and lower taxes is hard to pass up. Many U.S firms have a higher rate of return on their foreign investments than they do with their domestic ones.
When a firm decides to cross national borders, it faces of plethora of complex decisions. It is a riskier environment but also can be very rewarding when done correctly.
Block, S. B., & Hirt, G. A. (2013). Foundations of financial management: 14th edition
