International Finance I [CFI4102]

B.Com Finance

International Financial Management

Prepared by
Edson Mbedzi

Course Outline
1.

International Finance & introduction to multinational business.

2.

International Flow of Funds

3.

The Foreign Exchange Market

4.

Forecasting Exchange Rate Movements

5.
6.

International Financial Markets

Foreign Direct Investment

Topic 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.

 International

International Business
Management
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 etc.

Key international business financing decisions:

Whether to pursue new business in a particular country
Whether to expand business in a particular country

The International Business

Multinational Corporation (MNC)

Foreign Exchange Markets

Exporting
& Importing
Product Markets

Dividend
Remittance
& Financing

Subsidiaries

Investing
& Financing
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) Monitor 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

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 firms value, they may
be confronted with various environmental, regulatory, or ethical
constraints.

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).

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.
Ricardos 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.
9
Only one resource, that is labour is in use (that too, non-

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

8 tonnes

Zimbabwe

6 tonnes

According to Adam smith there is no benefit from specialisation,

nonetheless according to Ricardos explanation, when countries
decide what to produce or not they consider relative cost or implicit
cost reasoning illustrated below.
10

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.

USA
Zimbabwe

Cars
8/2=4
6/1=6

Beef
2/8=0.25
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.
11
Therefore both countries benefit provided the international market price

Implications of the Ricardian Model

Diminishing returns:
More a country produces, at some point, will require
more resources.
However:
Free trade can increase a countrys production
resources, and
Increase the efficiency of resource utilization.
International trade will only be of benefit if comparative
advantage exists, that is, if opportunity costs differ
between two countries.
12

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.

13

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

production are imperfect.

resources

used

in

Legal restrictions on movement of goods, people, and money

Transactions costs
Shipping costs
Tax arbitrage opportunities
NB: See the hec

14

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.

15

2a. Heckscher-Ohlin theory

Ricardos 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.

16

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
Kquickly
Y can
y
capital are used to produce both goods and
be
reallocated to
y ; Ly

x
K
;
L
x
x (food and clothing). i.e.
either of the sectors

Assumes a constant return to scale (CRS) production function. Thus, in

both countries there is the same state of technology (homogeneity of17 1 st

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 = (K, L), then this equation is said to be
K
X kK ;if:
L
homogeneity ofdegree
, 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
18
if capital and labour are scaled up by factor , the output is also increased

Constant Returns to Scale of

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
19
diminishing

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 Labundant (capital-scarce).
The physical symbolically measure is as follows:

K
K

LH
LF

--------------------------------------------1

20

Heckscher (1919)-Ohlin (1933) Theory

The 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.
21

Heckscher-Ohlin vs Ricardo

Economists prefer Heckscher on theoretical grounds but is a

relatively poor predictor of trade patterns.

Ricardos 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.

22

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.

23

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
24
mobility.

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.

25

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 ; Ly

The above production functions are assumed to be homogeneous of the

1st 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

S Sy

L Lx Ly

26

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.

27

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.

28

Theories of International Business

3. Product Cycle Theory

1
Firm creates
product to
accommodate
local demand.

2 International
trade

Firm exports product

to accommodate
foreign demand.

4a
Firm differentiates
product from
competitors and/or
expands product line in
foreign country.

or
4b
Firms foreign
business declines as
its competitive
advantages are
eliminated. [Exit]

3 FDI
Firm
establishes
foreign
subsidiary to
establish
presence in
foreign
country and
possibly to
reduce costs.

29

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.

30

Product Cycle Model and Trade

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
2. Limited initial demand in other advanced countries
Exports more attractive than production there initially.
3. With demand increase in advanced countries
Production follows there.
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
31

Product Lifecycle Model and trade

32

Examples of products that are currently at different

stages of the product life-cycle
Sector
IT

Communicati
on
Banking

INTRODUCT
ION
4rd
generation
mobile
phones
Econferencing
iris-based
personal
identity
cards

GROWTH

MATURITY

DECLINE

Portable DVD Personal

Players
Computers

Typewriters

Email

Faxes

Smart cards

Credit cards

Handwritten
letters
Cheque books

33

The international PLC

New product development

What is new product?
Major stages in new product development
Original products
Product improvements
Product modifications
New brands that the firm develops through its own research and
development efforts

34

Major stages in new product development

Marketing
Strategy
Development
Concept
Development
and Testing
Idea
Screening
Idea
Generation

Business
Analysis
Product
Development

Market
Testing

Commercialization

35

Probability of Success

Overall
probability
of success

Probability
of technical
completion

Probability of
commercialization
given technical
completion

Probability of
economic
success given
commercialization

Probability of
International
Expansion
36

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).
37

International Business Opportunities

Cost-benefit Evaluation for Purely Domestic Firms versus MNCs
Purely
Domestic
Firm

Marginal
Return on
Projects

MNC
MNC
Purely
Domestic
Firm

Marginal
Cost of
Capital

Appropriate Size
for Purely
Domestic Firm

Asset Level of Firm

Appropriate Size
for MNC

Y
38

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

39

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 worlds
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.

40

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. dollars in the near future

41

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
42

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.
dollar.

i) Recent surge in Canadian dollar value against

US

ii) SAs Shoprite loses in Malawi due the devaluation of the

Malawi
currency.

43

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 imports from Canada in 2002.
ii)
Complaints in South Africa about the Brazilian chicken
imports in
January 2013.
44

Top 10 MNCs by Revenues 2011

1

Wallmart

United States

Exxon Mobile Corporation

United States

Royal Dutch/Shell Group

Netherlands/ UK

BP

UK

Sinopec

China

Toyota Motor Corporation

Japan

Petro China

China

Total Fina SA

France

Chevron

United States

Japan Post Holdings

Japan

10

45

Overview of an MNCs Cash Flows

Profile A: MNCs focused on International Trade

U.S.based
MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

46

Overview of an MNCs Cash Flows

Profile B: MNCs focused on International Trade and
International Arrangements

U.S.based
MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

$ for service
cost of service

Foreign Firms
47

Overview of an MNCs Cash Flows

Profile C: MNCs focused on International Trade, International
Arrangements, and Direct Foreign Investment

U.S.based
MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

$ for service
cost of service

Foreign Firms

funds remitted
funds invested

Foreign Subsidiaries
48

Valuation Model for an MNC

Domestic Model
n

Value =

t =1

E CF$, t

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.
49

Valuation Model for an MNC

Valuing International Business Cash Flows

E CFj , t E ER j , t
j

Value =

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.
parent

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

company.

50

Valuation Model for an MNC

Impact of New International Opportunities on an MNCs Value
More Exposure to Foreign Economies
More Exposure to Exchange Rate Risk

Business Cycles
Inflation
Income levels
Interest rates

E CF E ER

Value =
t =1

j 1

Political Risk
Transfer Risk
Expropriation Risk
Regulatory Risk
Delivery Risk

j, t

j, t

Translation Exposure
Transaction Exposure
Economic Exposure

1 k

More Exposure to Country Risk

51

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:

1,5

t 1

million 1 million (0.09) 1 billion (0.125)

1 0.08 1

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

Thus, Value of the Firm = $117 212 962.96

52

Mini Case: Nikes 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 Nikes to develop their economies and raise the living
standards of their citizens. Recently, however, Nike came under a worldwide 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.
53

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

54