International Finance [CFI4102]

B. Commerce in Finance

International Financial Management

Lectured by

Edson Mbedzi
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 Topics in this Course
1. International Finance & introduction to multinational business.

2. International flow of funds and key funds drivers in Africa

3. The Foreign Exchange Market

4. Foreign Exchange Risk Management

5. International Capital Budgeting

6. International Treasury Management

7. Foreign Direct Investment

8. International Project financing

9. International Taxation

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 International Finance & introduction to
multinational business objectives
• To identify the main goal of the MNC and conflicts with that goal;

• To describe the key theories that justify international business; and

• To explain the common methods used to conduct international

business.

• Explain world opportunities that promote the relevance of

International business.

• Understand the importance of international financial environment on

the value of an international firm.
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 International Business Management
• International business is conducted through multinational corporations.

• Involves international investing and financing decisions.

• Starts with simple attempt to export products to a particular country or imports

from a foreign manufacturer, but over time recognise additional foreign
opportunities and eventually establish subsidiaries in foreign countries.

• Important to companies not involved in international business as well, to

evaluate how foreign competitors will be affected by movements in exchange
rates, foreign interest rates, labour costs, inflation, developments in foreign
economies etc.

• Key international business financing decisions:

• Whether to pursue new business in a particular country?
• Whether to expand business in a particular country?
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• How to finance expansion in a particular country?
 The International Business

Multinational Corporation (MNC)

Foreign Exchange Markets

Dividend
Remittance
Exporting & Financing Investing
& Importing & Financing

Product Markets Subsidiaries International

Financial
Markets 5
 Goal of the MNC
• The commonly accepted goal of an MNC is to maximize shareholder wealth.
• The role of international finance is to integrate all local and foreign operations in
a way that maximise firm value taking into account all operational, economic
and country risks involved.

• For corporations with shareholders who differ from their managers, a conflict of
goals can exist - the agency problem.

• Agency costs are normally larger for MNCs than for purely domestic firms, but
can vary with the management style of the MNC.
(1) Monitoring costs – overlook of managerial activities, such as audit costs;
(2) Restructuring costs (e.g. to limit managerial behaviour - board of directors and,
(3) Opportunity costs
(4) Bonding costs

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 Managing Agency Costs
• Various forms of corporate control can reduce agency problems;
(1) performance-based incentive plans (stock compensation),
(2) direct monitoring/intervention by shareholders,
(3) the threat of firing, and
(4) the threat of hostile takeover.

As MNC managers attempt to maximize their firm’s value, they may be

confronted with various environmental, regulatory, or ethical constraints.

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 Theories of International Business
Why are firms motivated to expand their business internationally – hence
importance of International Finance?
1. Theory of Comparative Advantage
 Specialization by countries can increase production efficiency based on
relative implicit cost/opportunity cost reasoning (David Ricardo, 1817).

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 1. The Theory of Comparative Advantage
David Ricardo: Principles of Political Economy (1817)

•Extends free trade argument.

•Efficiency of resource utilization leads to more productivity.
•Look to see how much more efficient, if only comparatively efficient, then import.
•Makes better use of resources.
•Trade is a positive-sum game.
Ricardo’s theory suggests that comparative advantage arises from
differences in productivity

Assumptions and limitations

Driven only by maximization of production and consumption.
Only 2 countries engaged in production and consumption of just 2 goods.
Does not take into account the transportation costs.
Only one resource, that is labour is in use (that too, non-transferable).

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 1. The Theory of Comparative Advantage
• In the Table the USA has a total absolute advantage in the production of both
cars and beef over Zimbabwe.

Cars Beef
USA 2 8 tonnes
Zimbabwe 1 6 tonnes

• According to Adam Smith there is no benefit from specialisation, nonetheless

according to Ricardo’s explanation, when countries decide what to produce or
not they consider relative cost or implicit cost reasoning illustrated below.

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 1. The Theory of Comparative Advantage
USA has lower opportunity cost ratio in the production of cars while Zimbabwe is
better in the production of beef.
To produce 1 car the USA requires 4 tonnes of beef equivalent while Zimbabwe
requires 6 tonnes instead. On the other hand, for Zimbabwe to produce 6 tonnes
of beef it foregoes 1 car, while USA foregoes 1 car to produce only 4 tonnes.

Cars Beef
USA 8/2=4 2/8=0.25
Zimbabwe 6/1=6 1/6=0.17

Thus USA produces cars and export to Zimbabwe while Zimbabwe produces more
beef and exports to the USA. Both Zimbabwe and USA benefit from specialisation
and trade if a mutually beneficial trading ratio is established.
Let us suppose 1 car is exchanged for 5 tonnes of beef in the international
markets, both the USA and Zimbabwe still gain from trade.
Therefore both countries benefit provided the international market price remains
between the two countries’ opportunity cost. 11
 Theories of International Business
Implications of comparative advantage to international markets

• International trade benefit if comparative advantage exists, that is, if opportunity

costs differ between two countries.

•Countries will only benefit from international business if international market

prices lie between the opportunity costs of the countries concerned.

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 Theories of International Business

2. Imperfect Markets Theory

• Goods differ in their factor requirements. Cars require more
capital per labour than furniture and aircraft requires more than
cars. Thus goods can be ranked by their factor intensity.

• Countries differ in factors endowments; some have more capital

than others. Thus countries can be ranked by factor abundance.

• The markets for the various resources used in production are

“imperfect.”
 Legal restrictions on movement of goods, people, and money
 Transactions costs
 Shipping costs
 Tax arbitrage opportunities
NB: See the Heckscher Theory. 13
 2a. Heckscher (1919)-Olin (1933) Theory
• Goods differ in their factor requirements. Cars require more capital per labour
than furniture and aircraft requires more than cars. Thus goods can be ranked by
their factor intensity.

• Countries differ in factors endowments; some have more capital than others.
Thus countries can be ranked by factor abundance.

• Export goods that intensively use factor endowments which are locally abundant.

– Corollary: import goods made from locally scarce factors.

• Patterns of trade are determined by differences in factor endowments - not

productivity.

• Remember, focus on relative advantage, not absolute advantage.

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 2a. Heckscher-Ohlin theory

Ricardo’s theory suggests that comparative advantage arises from differences in

productivity.

Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from
differences in national factor endowments – the extent to which a country is
endowed with resources like land, labor, and capital.

The Heckscher-Ohlin theory predicts that countries will export goods that make
intensive use of those factors that are locally abundant, while importing goods that
make intensive use of factors that are locally scarce.

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 Assumptions of the H-O Theory
•The model is hypothesised on two countries, two sectors and two inputs (labour
and capital), thus sometimes called the 2x2x2 model.
•It assumes that endowments of labour and capital differ across countries.
•It assumes perfectly competition goods market.
•Firms maximise profits (MR=MC).

•People demand both goods and tastes are the same in both countries. Called the
existence of homothetic preferences in both countries and it entails that the
preferences of the consumers in both countries are convex to the origin when
considered in terms of the indifference curves analysis.

•It assumes perfect substitutability of factors. Both inputs of labour and capital are
used to produce both goods and can be quickly reallocated to either of the sectors
(food and clothing). i.e.
Y   y K y ; L y 
X   xK x ; L x 
•Assumes a constant return to scale (CRS) production function. Thus, in both
countries there is the same state of technology (homogeneity of 1 st degree).

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 Returns to Scale
One important characteristic of production function is the response of output to
equi-proportional changes in both inputs. Returns to scale can be depicted using
isoquants. The distance between isoquants represents the extent to which output
of a good scales up or down in response to changes of factors of production. A
major assumption of the production function is that of the Constant Returns to
Scale (CRTS). This assumption is also called the Homogeneity of 1st degree and
illustrated as follows:


Definition of CRTS:
Let > 0, given that X = ƒ (K, L), then this equation is said to be homogeneity of
degree k if:  K X  K ; L 

, where k is the degree of homogeneity or homogeneous degree.

Using the equation, if K = 1, then such a function is said to be homogeneous.

Such a function defines constant returns to scale. A more formal macroeconomics
definition states that constant returns to scale prevails if capital and labour are
scaled up by factor , the output is also increased by factor as well. 17
 
X
Constant Returns to Scale of X

The doubling of factors capital K and labour L leads to output X to double. This
depicts the production function which is homogeneous of degree 1 (CRTS).
Two important Notes
The slopes of the isoquants along any ray from the origin under conditions of
homogeneity are equal.
The value of k determines the spacing between isoquants.
NB: Also note the difference between returns to scale and the law of diminishing

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 Heckscher (1919)-Olin (1933) Theory…

We define factor endowments in terms of the factor ratios between stocks of K and
L in the two countries.

If K/L ratio is greater in home country H than in foreign country F, then country H
is relatively K-abundant (labour-scarce) while country F is L-abundant (capital-
scarce).

The physical symbolically measure is as follows:

K K --------------------------------------------1

LH LF

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 Heckscher (1919)-Ohlin (1933) Theory…

The above theory can be explained in terms of factors price ratios as below and
note the change in equality sign when factors prices are used.
The physical symbolically measure is as follows:

PK PK

PLH PLF--------------------------------------------2

The Ohlin's theory concludes that:

The basis of international trade is the difference in commodity prices in the two
countries.
Differences in the commodity prices are due to cost differences which are the
results of differences in factor endowments in two countries.
A capital rich country specializes in capital intensive goods & exports them. While a
Labour abundant country specializes in labour intensive goods & exports them.
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 Heckscher-Ohlin vs Ricardo

• Economists prefer Heckscher on theoretical grounds but is a relatively poor

predictor of trade patterns.

• Ricardo’s Comparative Advantage Theory, regarded as too limited for

predicting trade patterns, actually predicts them with greater accuracy.

• In the end, differences in productivity may be the key to determining trade

patterns.

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 Conclusion of H-O Theory
The Ohlin's theory concludes that:

•The basis of international trade is the difference in commodity prices in the two
countries.

•Differences in the commodity prices are due to cost differences which are the
results of differences in factor endowments in two countries.

•A capital rich country specializes in capital intensive goods & exports them. While
a Labour abundant country specializes in labour intensive goods & exports them.

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 2b. The Specific-Factor Model or New Trade Theory
Modern international trade economists are interested in models that go beyond the
H-O model.

The H-O assumption of free factor mobility between industries is only attainable in
the long-run (long enough to allow conversion of a factor from one industry to
another).

Capital is fixed in its sectorial usage (Specific-Factor Model)

Time is required for capital mobility between diverse industries for physical capital
to depreciate in one industry and for new investment to take place in another.
Economists distinguish between:
Short-run: a period of time in which at least one factor is fixed in the production function,
corresponding to capital specificity theory.
Long-run: a period of time in which all factors are variable in the production functions;
thereby corresponding to the inter-sectorial factor mobility.

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 2b. The Specific-Factors Model Assumptions
Similar Assumptions to H-O Model
•Two goods are produced with production functions that exhibit Constant Rate of
Returns (CRTS).
•Two factors of production are required for both production functions.
•Tastes are homogeneous and identical for all consumers which allowed the
representation of preferences by the Community Indifference Curves (CICs).

Different Assumptions to H-O Model

Only labour is homogeneous and common to the two production functions, but
capital is fixed by industry in the short-run.

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 The production functions of the model are shown
below:
The production functions of the model are shown below:

X   xR x ; L x  Y   y S y ; L y 
The above production functions are assumed to be homogeneous of the 1 st degree
and also increasing functions of both inputs. It is also assumed that positive
outputs are a product of positive inputs of both factors.

The economy is assumed to have fixed total supply of both K and L and these two
constraints are represented by equation below:

K  Kx  Ky L  Lx  Ly
It is also assumed that the two processes use all the available K and L, that full
employment is assumed.
Based on the factor supply of equations above, we deduce the following equations
under the specific factors model:
R  Rx
L  Lx  Ly 25
S  Sy
 Implications of the Specific-Factor Model
The 3 equations above show that the entire available stock of factor R is used to
produce good X while the entire endowment of factor S is used to produce
commodity Y.

Thus return to capitals R and S are “r” and “s” respectively due specificity of K.

The return to labour, L is “w”, which is the same for both industries due to free
mobility of L.

The model then can be simplified as a theory with two goods and three factors.

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 Implications for Trade & Business
• Location implications: makes sense to disperse production activities to countries
where they can be performed most efficiently.

• First-mover implications: It pays to invest substantial financial resources in

building a first-mover, or early-mover, advantage.

• Policy implications: promoting free trade is generally in the best interests of the
home-country, although not always in the best interests of the firm. Even
though, many firms promote open markets.

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 Theories of International Business

3. Product Life-Cycle Theory & Trade

• As products mature, both location of sales and optimal production changes.

• Affects the direction and flow of imports and exports.

• Globalization and integration of the economy makes this theory less valid.

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 Product Cycle Model and Trade

Stage 1. Firms keep production close to the market

Aid decisions; minimize risk of new product introductions
Demand not based on price yet; low production cost not an issue1

Stage 2. Limited initial demand in other advanced countries

Exports more attractive than production there initially.

Stage 3. With demand increase in advanced countries

Production follows there.

Stage 4. With demand expansion elsewhere

Product becomes standardized
production moves to low production cost areas
Product now imported to original country and to advanced countries

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 Theories of International Business

Product Cycle Theory

1 2 International
trade 3 FDI
Firm creates product Firm exports product to
to accommodate accommodate foreign Firm establishes
local demand. demand. foreign
subsidiary to
establish
presence in
4a or foreign country
4b and possibly to
Firm differentiates product reduce costs.
from competitors and/or Firm’s foreign business
expands product line in declines as its
foreign country. competitive advantages
are eliminated. [Exit]

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 Examples of products at different stages of the product life-cycle

Sector Introduction Growth Maturity Decline

IT 4rd generation Laptops Personal Typewriters

mobile phones Computers

Communication E-communication Email Faxes Handwritten

letters
Banking iris-based Smart cards Credit cards Cheque books
personal identity
cards

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 International Business Methods
• International Trade - a relatively conservative approach involving exporting
and/or importing.

• Licensing - provision of technology in exchange for fees or some other benefits.

• Franchising - provision of a specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange for
periodic fees.

• Joint Ventures - joint ownership and operation by two or more firms.

• Acquisitions of Existing Operations

• Establishing New Foreign Subsidiaries

Any method of increasing international business that requires a direct investment
in foreign operations normally is referred to as a direct foreign investment
(DFI).
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 International Business Opportunities
Cost-benefit Evaluation for Purely Domestic Firms versus MNCs

Purely
Domestic
Firm MNC
Marginal
Return on
Projects MNC
Purely
Marginal Domestic
Cost of Firm
Capital
Appropriate Size
for Purely Appropriate Size
Domestic Firm for MNC

X Y
Asset Level of Firm 33
 International Opportunities

• Global Opportunities in Globalized Financial Markets

Deregulation of Financial Markets

coupled with

Advances in Technology have greatly reduced information and

transactions costs, which has led to:

Financial Innovations, such as

Currency futures and options
Multi-currency bonds
Cross-border stock listings
International mutual funds
Global supply chain

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 International Business Opportunities

• Growth in World Trade

• Over the past 50 years, international trade increased about twice as fast
as world GDP.

• There has been a sea change in the attitudes of many of the world’s
governments who have abandoned mercantilist views and embraced free trade
as the surest route to prosperity for their citizenry.

• The General Agreement on Tariffs and Trade-GATT (later replaced with WTO)
a multilateral agreement among member countries has reduced many barriers
to trade.

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 International Business Opportunities

• Opportunities in Europe
– Single European Community Act of 1987
– Removal of the Berlin Wall in 1989
– Single currency system in 1999

• Currently more than 320 million Europeans in 17 countries are using the
common currency on a daily basis (Belgium, Germany, Greece, Spain, France,
Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Slovenia,
Slovakia, Estonia, Finland, Malta, and Cyprus).

• The “transaction domain” of the euro may become larger than the U.S. dollar’s
in the near future

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 International Business Opportunities

• Opportunities in Latin America

¤ North American Free Trade Agreement (NAFTA) of 1993

• The North American Free Trade Agreement (NAFTA) calls for phasing out of
impediments to trade between Canada, Mexico and the U.S. over a 15-year
period.

For Canada, the ratio of exports to GDP has increased dramatically from
19.2% in 1973 to 45.2% in 2003.
The increased trade will result in increased numbers of jobs and a higher
standard of living for all member nations.

Opportunities in Asia
Significant growth expected for China
Asian economic crisis in 1997-1998

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 Exposure to International Business Risk

• Exposure to Exchange Rate Movements

– exchange rate fluctuations affect cash flows and foreign demand.

– The risk that foreign currency profits may evaporate in home currency terms
due to unanticipated unfavorable exchange rate movements.

e.g. i) Recent surge in Canadian dollar value against US dollar.

ii) SA’s Shoprite loses in Malawi due the devaluation of the

Malawi currency.

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 Exposure to International Business Risk

• Exposure to Foreign Economies

 Foreign economic conditions affect demand, and therefore cash flows.

• Exposure to Political Risk

 political actions affect cash flows.

 Sovereign governments have the right to regulate the movement of goods,

capital, and people across their borders. These laws sometimes change in
unexpected ways.

e.g. i) Chinese ban on canola (chocolates) imports from Canada in 2002.

ii) Complaints in South Africa about the Brazilian chicken
imports in January 2013.

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 Top 10 MNCs by Revenues 2011

1 Wallmart United States

2 Exxon Mobile Corporation United States
3 Royal Dutch/Shell Group Netherlands/ UK
4 BP UK
5 Sinopec China
6 Toyota Motor Corporation Japan
7 Petro China China
8 Total Fina SA France
9 Chevron United States
10 Japan Post Holdings Japan

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 Overview of an MNC’s Cash Flows

Profile A: MNCs focused on International Trade

$ for products U.S. Customers

U.S.- $ for supplies
U.S. Businesses
based
MNC $ for exports Foreign Importers
$ for imports
Foreign Exporters

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 Overview of an MNC’s Cash Flows

Profile B: MNCs focused on International Trade and International

Arrangements

$ for products
U.S. Customers
$ for supplies U.S. Businesses

U.S.- $ for exports

based Foreign Importers
MNC $ for imports Foreign Exporters
$ for service
cost of service Foreign Firms

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 Overview of an MNC’s Cash Flows
Profile C: MNCs focused on International Trade, International
Arrangements, and Direct Foreign Investment
$ for products U.S. Customers
$ for supplies U.S. Businesses

U.S.- $ for exports Foreign Importers

based
MNC $ for imports Foreign Exporters
$ for service
cost of service Foreign Firms
funds remitted
funds invested Foreign Subsidiaries
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 Valuation Model for an MNC

• Domestic Model

n E  CF$, t 
Value =  t
t =1 1  k
where E (CF$,t ) = expected cash flows to be received at the end of
period t.
n = the number of periods into the future in which
cash flows are received.
k = the required rate of return by investors.

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 Valuation Model for an MNC
Valuing International Business Cash Flows
m 

n  j 1

 E  CFj , t   E  ER j , t   

Value =   t 
t =1 1  k 

 

where E (CFj,t ) = expected cash flows denominated in currency j to be received
by the U.S. parent at the end of period t.

E (ERj,t ) = expected exchange rate at which currency j can be converted

to dollars at the end of period t.

k = the weighted average cost of capital of the U.S. parent

company.
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 Valuation Model for an MNC
Impact of New International Opportunities on an MNC’s Value

More Exposure to Foreign Economies

Business Cycles More Exposure to Exchange Rate Risk

Inflation
Income levels
Interest rates  m 
n 
 
E CF j , t  E ER j , t  
Translation Exposure
Transaction Exposure
 j 1 
Value =    Economic Exposure
t =1  1  k  t


 


Political Risk
Transfer Risk More Exposure to Country Risk
Expropriation Risk
Regulatory Risk
Delivery Risk 46
Example

Consider an MNC based in the US with operations in Mexico and RSA. The firm
expects cash flows of $1 500 000 from local business, 1 000 000 Mexican peso from
Mexico subsidiary and 1 billion rand from RSA at the end of period 1. Assuming the
future exchange rate of the peso is expected to be $0.09 and that of the rand is
expected to be $0.125. The expected weighted average cost of capital of the MNC is
8%, the value of the firm is:


n 

1,5 million  1 million (0.09)  1 billion (0.125) 
 
V   
t 1  1  0.081 

 


V = (1500 000+ 90 000+125 000 000)/1.08

Thus, Value of the Firm = $117 212 962.96

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 Mini Case: Nike’s Decision
Nike, a U.S.-based company with a globally recognized brand name,
manufactures athletic shoes in such Asian developing countries as China,
Indonesia, and Vietnam using subcontractors, and sells the products in the U.S.
and foreign markets. The company has no production facilities in the United States.
In each of those Asian countries where Nike has production facilities, the rates of
unemployment and underemployment are quite high. The wage rate is very low in
those countries by the U.S. standard; hourly wage rate in the manufacturing sector
is less than one dollar in each of those countries, which is compared with about
$18 in the U.S. In addition, workers in those countries often are operating in poor
and unhealthy environments and their rights are not well protected.
Understandably, Asian host countries are eager to attract foreign investments like
Nike’s to develop their economies and raise the living standards of their citizens.
Recently, however, Nike came under a world-wide criticism for its practice of hiring
workers for such a low pay, “next to nothing” in the words of critics, and
condoning poor working conditions in host countries.

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Group 1 Assignment
a)Using relevant literature, provide a theoretical framework for international
business. (10 marks)
b)Evaluate and discuss various ‘ethical’ as well as economic implications of Nike’s
decision to invest in Asian countries. (8 marks)
c)Is the exploitation and plundering of resources by MNCs in developing countries
responsible for their slow economic growth? (8
marks)
d)What can be done by host countries to reduce the level of exploitation by foreign
MNCs without compromising FDI? (4
marks)

Due date: Friday 25 October 2019 at 4pm.

NB: Group members must not exceed 8 memebrs

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