GOAL OF MULTINATIONAL COMPANIES (MNCs)

Multinational Financial Management: an overviewGoal of multinational companies (MNCs):         Wealth maximization of share holders       There are two ways to maximize the wealth:           Capital Gain           Dividend IncreaseMNCs Definition:            When the domestic company started its business in different countries is called MNCs.               Parent Company: Domestic branch is called main or parent company.              Subsidires Company: In other countries branches is called Subsidires Company.Conflicts with Goal:            Agencies problems            Management and share Holder’s problemsHow to remove conflicts:            Stock offer            Centralized decision            Threat of job            MonetaryConstraints with MNCs Goal:

          Environmental issues           Regulatory constraints           Ethical

International Business Theories:

Comparative Advantage: Which area the company is stronger than other company and its competitor is weak in that area Theory of Imperfect Market: Get the benefit of factor of production because the factor are not equal in the world the business man can get the befit of that inequality. Product Life cycle Theory: first of all fulfill domestic demand and after fulfill MNCs demand.

Goals of the MNC• Maximize shareholder wealth

– Problems encountered in meeting goals:

1) Agency problems larger for MNCs than purely domestic firms because:

a) monitoring more difficult because of geographic distance

b) different cultures

c) MNC sized) subsidiary managers may maximize the value of their subsidiary but not of the

MNC as a whole

2) Centralized vs. decentralized management

a) centralized reduces agency costs because it gives parent more

control; downside is that local managers may be better

informed

b) decentralized management increases agency costs but may

result in better decisionsc) Internet may facilitate monitoring of foreign subsidiaries

3) Corporate control used to reduce agency problems

a) executive compensation with stock b) threat of hostile takeoverc) monitoring by large shareholders

– Constraints encountered in meeting goals

1) Environmental - other countries may be tougher (e.g., pollution

controls)

2) Regulatory - e.g., currency convertibility, remittance of profits, etc.3) Ethical - e.g., bribes may be more acceptable in other countries

Factors which influence the exchange rateExchange rates are determined by supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value)

of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar.

Note:

Appreciation = increase in value of exchange rate Depreciation / devaluation = decrease in value of exchange rate.

Main Factors that Influence Exchange Rates1. InflationIf inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy less imports.Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.2. Interest RatesIf UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. You will get a better rate of return from saving in UK banks, Therefore demand for Sterling will rise.  This is known as “hot money flows” and is an important short run factor in determining the value of a currency. Higher interest rates cause anappreciation.

3. SpeculationIf speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.

4. Change in CompetitivenessIf British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.

5. Relative strength of other currencies.

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were worried about all the other major economies – US and EU. Therefore, despite low interest rates and low growth in Japan, the Yen kept appreciating.

6. Balance of PaymentsA deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows to finance a current account deficit, will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of dollar in 2006-07)

7. Government Debt.Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a rapid fall in the value of the Icelandic currency.

For example, if markets feared the US would default on its debt, foreign investors would sell their holdings of US bonds. This would cause a fall in the value of the dollar.

8. Government InterventionSome governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

9. Economic growth / recessionA recession may cause a depreciation in the exchange rate because during a recession interest rates usually fall. However, there is no hard and fast rule. It depends on several factors.

Determinants of Exchange RatesNumerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of thecurrencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many

aspects ofeconomics, the relative importance of these factors is subject to much debate.

1. Differentials in InflationAs a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

2. Differentials in Interest RatesInterest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)

3. Current-Account DeficitsThe current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. Adeficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)

4. Public DebtCountries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation

is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. 

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate. 

5. Terms of TradeA ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic PerformanceForeign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.