CHAPTER 1
INTRODUCTION
Chapter 1 emphasizes the internationalization of business and economic activity that has occurred
since the end of World War II. Although international business activities have existed for centuries,
primarily in the form of exporting and importing, it is only in the postwar period that multinational
firms have become preeminent. The distinguishing characteristic of the MNC is its emphasis on
global, rather than affiliate, performance. Specifically, MNCs ask, "Where in the world should we
build our plants, sell our products, raise capital, and hire personnel?" Thus the true multinational is
characterized more by attitude than the physical reality of an integrated system of marketing and
production activities worldwide. It involves looking beyond the boundaries of the home country,
and treating the world as "our oyster." Good examples include the globalization of GE's medical
systems division and Arco Chemical.
After stimulating student interest with this vision of the MNC, I then introduce the financial decisions that
multinationals must make. I begin by discussing the key concepts and lessons from domestic finance that
apply directly to international corporate finance. The lessons include the emphasis on cash flow rather than
accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to
reward companies for activities (like corporate diversification) which investors could replicate for
themselves at no greater cost.
The key concepts, which I point out will arise time and again in the course, are arbitrage, market
efficiency, and the separation of risk into systematic risk, which must be rewarded, and
unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying
both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although
imperfect, the theoretical framework of domestic corporate finance provides a useful frame of
reference, and understanding it is essential before proceeding with the more complex aspects of
international financial management. I devote some time to explaining that total risk matters, even if
the CAPM or APT holds. Otherwise the astute student will see a conflict between the irrelevance of
unsystematic risk and hedging activities.
I then outline the key decision areas in international financial management: foreign exchange risk
management, managing working capital and the internal financial system, financing foreign units, capital
budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial executives
must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as
foreign exchange and political risks.
, SUGGESTED ANSWERS TO “GENERAL ELECTRIC GLOBALIZES”
1. What advantages does General Electric seek to attain from its international business activities?
ANSWER. Aside from gaining access to markets worldwide, GE focuses on taking advantage of its global reach
to find less expensive materials abroad and intellectual capital, thereby lowering its cost of designing and
manufacturing products.
1. What actions is it taking to gain these advantages from its international activities?
ANSWER. GE is acquiring companies abroad, and setting up joint ventures with other foreign companies, to
gain their assets and ability to service local customers. It is setting up manufacturing facilities abroad to
access lower cost labor and materials and also sourcing more purchases abroad for the same reasons. It also
is identifying and hiring engineering and scientific talent from around the world to boost its intellectual
capital and is setting up R&D facilities where this talent can work.
2. What risks does GE face in its foreign operations?
ANSWER. Potential increased risks from global operations include, among other things, currency risks, higher
receivables delinquencies and bad debts, delays or cancellation of sales and orders, higher local currency
financing costs, and a slowdown in established financial services activities.
3. What profit opportunities for GE can arise out of these risks?
ANSWER. New profit opportunities for GE include, among other things, lower costs of goods sourced from
countries with weakened currencies, more opportunities for lower cost outsourcing, expansion of
industrial and financial services activities through purchases of companies or assets at reduced prices
and lower U.S. debt financing costs.
, SUGGESTED ANSWERS TO “DEMOCRATS TURN PROTECTIONIST”
1. What might explain the candidates’ and Democratic Party’s reversal of position on free trade? Which
voting constituencies would be most likely to reject free trade? Why?
ANSWER. The Democratic Party is heavily reliant on union votes and money. And unions, particularly the
industrial unions that make up the core of the union movement is against free trade because it subjects
their members to competition from foreign labor embodied in foreign goods and services. The candidates
themselves are trying to appeal to the unions as they are among the best organized segment of the
Democratic Party and have the ability to turn out votes in primaries where few voters go to the polls.
Given the low turnout, a primary is often determined by the most committed voters, who are often union
members threatened with job losses from free trade.
2. What leverage do the trade unions have in persuading Al Gore and other Democratic candidates to
pay attention to their anti-free -trade position? Explain why these particular unions might be
particularly powerful.
ANSWER. The unions’ leverage stems from the fact that their membership is concentrated in six large
industrial states that are crucial swing states in presidential elections. Al Gore needs these states with
their large vote totals to win a national election. There are enough industrial union members in these six
states that they could tip a close race. If the union membership were dispersed throughout the United
States, their leverage would be greatly diminished since they couldn’t concentrate their votes to deliver
key states.
3. What trade-offs do Al Gore and other Democrats face in accommodating labor? Explain.
ANSWER. If Al Gore gives in to protectionist sentiment to accommodate these industrial unions, he risks
losing states like California (Silicon Valley), Washington (Boeing), New York (Wall Street), and New
Jersey (pharmaceutical firms) that depend on foreign trade for their livelihood. For example, Gore has
made a particular push to gain money and votes from Silicon Valley, which is highly dependent on
exports. Pushing protectionist policies could lead to a backlash against Gore from Silicon Valley
executives who understand that foreign countries would likely retaliate against U.S. products. Moreover,
a protectionist stance could cost Gore farm state votes as well because farmers are highly dependent on
exports. Gore also has to be concerned that he will lose the votes of middle-of-the-road Democrats and
independents if he is viewed–as Walter Mondale was–as a tool of labor.
4. How can U.S. manufacturers compete with foreign producers? Are they doomed, as suggested by the
president of the United Steelworkers of America?. Explain.
ANSWER. The objective evidence shows that U.S. manufacturers can compete against foreign producers,
although not across the board. Rather, U.S. firms have a comparative advantage in a number of high
technology industries and industries where close coordination between customer and producer is key
(such as fashion design). In fact, U.S. industrial output is up but the number of manufacturing jobs has not
risen; it’s just that higher productivity means that companies don’t have to hire as many new workers to
produce the higher output. U.S. companies also have a comparative advantage in many service industries,
such as financial services, consulting, and telecommunications.
5. Are the unions and their members right to be concerned about the effects of free -trade policies?
What are these effects that they are concerned about? Who would be helped and who would be hurt
if the unions got their way on trade? Explain.
ANSWER. Yes. The industrial unions have set wages and benefits well above market levels. They were able
to get away with such high levels of compensation as long as they were not facing competition from
lower-paid foreign workers whose labor is embodied in imported products. Lower-priced foreign
imports will put pressure on competing U.S. goods and, therefore, on the compensation enjoyed by
, industrial union members. Thus, protectionist policies will protect the wages and benefits of these union
workers. At the same time, they will lead to higher prices to U.S. consumers of both foreign goods and
services and the domestic goods and services that compete with them. A less obvious effect will be the
harm caused to companies that export. Protectionism will lead to less demand for foreign exchange,
thereby raising the value of the dollar and making U.S. exports less competitive overseas.
SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS
1.a. What are the various categories of multinational firms?
ANSWER. Raw materials seekers, market seekers, and cost minimizers .
b. What is the motivation for international expansion of firms within each category?
ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be found there. It just
happens that nature didn't place all natural resources domestically. Market seekers go overseas to produce
and sell in foreign markets. The cost minimizers invest in lower-cost production sites overseas in order to
remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is
larger than the home country and provides opportunities to gain additional supplies, sell more products or
find lower cost sources of production.
2.a. How does foreign competition limit the prices that domestic companies can charge and the wages and
benefits that workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less expensive goods and
services supplied by foreign producers. The likelihood of losing sales limits the prices that domestic firms can
charge. Foreign competition also acts to limit the wages and benefits that workers can demand. If workers
demand more money, firms have two choices. Acquiesce in these demands or fight them. Absent foreign
competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms
will face the same higher costs, they can cover these higher costs by all of them simultaneously raising their
prices without fear of being undercut or of being placed at a competitive disadvantage relative to their peers.
Foreign competition changes the picture since foreign firms' costs will be unaffected by higher domestic
wages and benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the
market and take market share away. In this case, higher domestic costs will put domestic firms at a
INTRODUCTION
Chapter 1 emphasizes the internationalization of business and economic activity that has occurred
since the end of World War II. Although international business activities have existed for centuries,
primarily in the form of exporting and importing, it is only in the postwar period that multinational
firms have become preeminent. The distinguishing characteristic of the MNC is its emphasis on
global, rather than affiliate, performance. Specifically, MNCs ask, "Where in the world should we
build our plants, sell our products, raise capital, and hire personnel?" Thus the true multinational is
characterized more by attitude than the physical reality of an integrated system of marketing and
production activities worldwide. It involves looking beyond the boundaries of the home country,
and treating the world as "our oyster." Good examples include the globalization of GE's medical
systems division and Arco Chemical.
After stimulating student interest with this vision of the MNC, I then introduce the financial decisions that
multinationals must make. I begin by discussing the key concepts and lessons from domestic finance that
apply directly to international corporate finance. The lessons include the emphasis on cash flow rather than
accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to
reward companies for activities (like corporate diversification) which investors could replicate for
themselves at no greater cost.
The key concepts, which I point out will arise time and again in the course, are arbitrage, market
efficiency, and the separation of risk into systematic risk, which must be rewarded, and
unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying
both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although
imperfect, the theoretical framework of domestic corporate finance provides a useful frame of
reference, and understanding it is essential before proceeding with the more complex aspects of
international financial management. I devote some time to explaining that total risk matters, even if
the CAPM or APT holds. Otherwise the astute student will see a conflict between the irrelevance of
unsystematic risk and hedging activities.
I then outline the key decision areas in international financial management: foreign exchange risk
management, managing working capital and the internal financial system, financing foreign units, capital
budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial executives
must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as
foreign exchange and political risks.
, SUGGESTED ANSWERS TO “GENERAL ELECTRIC GLOBALIZES”
1. What advantages does General Electric seek to attain from its international business activities?
ANSWER. Aside from gaining access to markets worldwide, GE focuses on taking advantage of its global reach
to find less expensive materials abroad and intellectual capital, thereby lowering its cost of designing and
manufacturing products.
1. What actions is it taking to gain these advantages from its international activities?
ANSWER. GE is acquiring companies abroad, and setting up joint ventures with other foreign companies, to
gain their assets and ability to service local customers. It is setting up manufacturing facilities abroad to
access lower cost labor and materials and also sourcing more purchases abroad for the same reasons. It also
is identifying and hiring engineering and scientific talent from around the world to boost its intellectual
capital and is setting up R&D facilities where this talent can work.
2. What risks does GE face in its foreign operations?
ANSWER. Potential increased risks from global operations include, among other things, currency risks, higher
receivables delinquencies and bad debts, delays or cancellation of sales and orders, higher local currency
financing costs, and a slowdown in established financial services activities.
3. What profit opportunities for GE can arise out of these risks?
ANSWER. New profit opportunities for GE include, among other things, lower costs of goods sourced from
countries with weakened currencies, more opportunities for lower cost outsourcing, expansion of
industrial and financial services activities through purchases of companies or assets at reduced prices
and lower U.S. debt financing costs.
, SUGGESTED ANSWERS TO “DEMOCRATS TURN PROTECTIONIST”
1. What might explain the candidates’ and Democratic Party’s reversal of position on free trade? Which
voting constituencies would be most likely to reject free trade? Why?
ANSWER. The Democratic Party is heavily reliant on union votes and money. And unions, particularly the
industrial unions that make up the core of the union movement is against free trade because it subjects
their members to competition from foreign labor embodied in foreign goods and services. The candidates
themselves are trying to appeal to the unions as they are among the best organized segment of the
Democratic Party and have the ability to turn out votes in primaries where few voters go to the polls.
Given the low turnout, a primary is often determined by the most committed voters, who are often union
members threatened with job losses from free trade.
2. What leverage do the trade unions have in persuading Al Gore and other Democratic candidates to
pay attention to their anti-free -trade position? Explain why these particular unions might be
particularly powerful.
ANSWER. The unions’ leverage stems from the fact that their membership is concentrated in six large
industrial states that are crucial swing states in presidential elections. Al Gore needs these states with
their large vote totals to win a national election. There are enough industrial union members in these six
states that they could tip a close race. If the union membership were dispersed throughout the United
States, their leverage would be greatly diminished since they couldn’t concentrate their votes to deliver
key states.
3. What trade-offs do Al Gore and other Democrats face in accommodating labor? Explain.
ANSWER. If Al Gore gives in to protectionist sentiment to accommodate these industrial unions, he risks
losing states like California (Silicon Valley), Washington (Boeing), New York (Wall Street), and New
Jersey (pharmaceutical firms) that depend on foreign trade for their livelihood. For example, Gore has
made a particular push to gain money and votes from Silicon Valley, which is highly dependent on
exports. Pushing protectionist policies could lead to a backlash against Gore from Silicon Valley
executives who understand that foreign countries would likely retaliate against U.S. products. Moreover,
a protectionist stance could cost Gore farm state votes as well because farmers are highly dependent on
exports. Gore also has to be concerned that he will lose the votes of middle-of-the-road Democrats and
independents if he is viewed–as Walter Mondale was–as a tool of labor.
4. How can U.S. manufacturers compete with foreign producers? Are they doomed, as suggested by the
president of the United Steelworkers of America?. Explain.
ANSWER. The objective evidence shows that U.S. manufacturers can compete against foreign producers,
although not across the board. Rather, U.S. firms have a comparative advantage in a number of high
technology industries and industries where close coordination between customer and producer is key
(such as fashion design). In fact, U.S. industrial output is up but the number of manufacturing jobs has not
risen; it’s just that higher productivity means that companies don’t have to hire as many new workers to
produce the higher output. U.S. companies also have a comparative advantage in many service industries,
such as financial services, consulting, and telecommunications.
5. Are the unions and their members right to be concerned about the effects of free -trade policies?
What are these effects that they are concerned about? Who would be helped and who would be hurt
if the unions got their way on trade? Explain.
ANSWER. Yes. The industrial unions have set wages and benefits well above market levels. They were able
to get away with such high levels of compensation as long as they were not facing competition from
lower-paid foreign workers whose labor is embodied in imported products. Lower-priced foreign
imports will put pressure on competing U.S. goods and, therefore, on the compensation enjoyed by
, industrial union members. Thus, protectionist policies will protect the wages and benefits of these union
workers. At the same time, they will lead to higher prices to U.S. consumers of both foreign goods and
services and the domestic goods and services that compete with them. A less obvious effect will be the
harm caused to companies that export. Protectionism will lead to less demand for foreign exchange,
thereby raising the value of the dollar and making U.S. exports less competitive overseas.
SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS
1.a. What are the various categories of multinational firms?
ANSWER. Raw materials seekers, market seekers, and cost minimizers .
b. What is the motivation for international expansion of firms within each category?
ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be found there. It just
happens that nature didn't place all natural resources domestically. Market seekers go overseas to produce
and sell in foreign markets. The cost minimizers invest in lower-cost production sites overseas in order to
remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is
larger than the home country and provides opportunities to gain additional supplies, sell more products or
find lower cost sources of production.
2.a. How does foreign competition limit the prices that domestic companies can charge and the wages and
benefits that workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less expensive goods and
services supplied by foreign producers. The likelihood of losing sales limits the prices that domestic firms can
charge. Foreign competition also acts to limit the wages and benefits that workers can demand. If workers
demand more money, firms have two choices. Acquiesce in these demands or fight them. Absent foreign
competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms
will face the same higher costs, they can cover these higher costs by all of them simultaneously raising their
prices without fear of being undercut or of being placed at a competitive disadvantage relative to their peers.
Foreign competition changes the picture since foreign firms' costs will be unaffected by higher domestic
wages and benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the
market and take market share away. In this case, higher domestic costs will put domestic firms at a
