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, only in the postwar period have multinational
firms 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 MNC is characterized
more by attitude than the physical reality of an integrated, global system of marketing and
production activities. It involves looking beyond the boundaries of the home country and treating
the world as “our oyster.”
After stimulating student interest with this vision of the MNC, I then introduce the financial
decisions that MNCs 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)
that 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 “THE DEBATE OVER OUTSOURCING”
1. What are the pros and cons of outsourcing?
ANSWER. PROS: Outsourcing enables Americans to buy services less expensively abroad, increases
U.S. productivity, and enables U.S. companies to cut their costs while improving quality, time to
market, and capacity to innovate. It also allows the U.S. to use its comparative advantage in
financial, managerial, and technical services by specializing in and exporting such services as
higher-end computer programming, management consulting, engineering, banking,
telecommunications, and legal work.
CONS: As with any kind of trade, importing of services through outsourcing results in the loss of jobs
for Americans previously employed in providing those services. Outsourcing may also cause U.S.
companies that provide these services to go out of business.
2. How does outsourcing affect U.S. consumers? U.S. producers?
ANSWER. As the answer to part a) points out, outsourcing allows companies to buy services less
expensively abroad. Competitive pressures force companies to pass these savings along to
consumers in the form of lower-priced goods and services.
U.S. producers are able to boost productivity and cut costs while improving quality, time to market,
and capacity to innovate. As such, American companies are better able to compete. This
competition, however, forces companies to pass most of their savings from outsourcing through to
their customers.
3. Longer term, what is the likely impact of outsourcing on American jobs?
ANSWER. The longer-term effect of outsourcing on U.S. jobs should be insignificant. Trade has little,
if anything, to do with the quantity of jobs in an economy but rather the nature and distribution of
those jobs in various occupations. Outsourcing should lead to higher average productivity of those
jobs that Americans work at and, hence, to higher wages and benefits.
4. Several states are contemplating legislation that would ban the outsourcing of
government work to foreign firms. What would be the likely consequences of such
legislation?
ANSWER. Such legislation would result in less efficient and more expensive government. The end
result would be higher taxes or, if taxpayers balk, fewer government services.
SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONSNumber range CHAPTER
1. Explain how globalization may affect even a small business in your local area.
ANSWER. Globalization entails opening national borders to enable freer movement of goods and
services. Due to the rapid decrease in communication and transportation costs over the last few
decades, many firms find it cheaper to source products from foreign countries. Also, firms are now
aware of international market opportunities and locate their plants and facilities abroad. As a
, result, the competition faced by any business is now more global rather than merely local. A small
business in any local area now faces competition from both large MNCs and similarly situated
businesses that take advantage of their international experience as well as internationally sourced
products.
2. Opponents of globalization and outsourcing argue that locating manufacturing activities
abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather
than resulting in a net loss of jobs, employment has actually increased. Also, the average
wages of workers have increased. How would you account for this discrepancy between
what the critics say and what statistics reveal?
ANSWER. Globalization is a two-way street. While some U.S. firms locate their plants overseas,
several foreign companies have also invested in the U.S. economy and located their plants here. For
example, major foreign automobile manufacturers such as Toyota and BMW have set up
manufacturing plants in the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the
U.S. economy has experienced unprecedented productivity growth due to the increase in trade from
globalization. The net impact of this productivity growth as measured in output per hour has been
such as to increase the inflation-adjusted worker compensation. Thus, while critics of globalization
look at only one side of the picture and point to job losses due to outsourcing, they neglect to take
into account the job creation due to foreign investment in the U.S. and the increase in trade due to
globalization. Critics also ignore the fact the increased opportunities for trade due to globalization
result in high-value-added services being performed in the U.S. and the increase in productivity of
the U.S. worker. As a result, worker wages have also gone up.
3. Elaborate on the benefits of a proactive approach to globalization and global
competition.
ANSWER. Rather than react to globalization, firms benefit by facing globalization and global
competition head on. Globalization and global competition unleash the forces of creative
destruction, whereby new technologies and new methods of business force out poorly performing
competitors. To take advantage of the full potential of globalization and to counter global
competition, many firms adopt new technologies, improve production methods, explore new
markets, and introduce new and better products. The results of such improvements are clear in
terms of the lower prices and expanded choices for consumers. Thus, proactive firms stay ahead of
their competition by taking advantage of the various benefits of globalization and the expanded
trade opportunities.
4. What are the various reasons for the emergence of multinational firms?
ANSWER. The primary reason for the emergence of MNCs is the international mobility of several
factors of production. MNCs emerge to take advantage of globally available raw materials, markets,
specialized skills, and knowledge. Also, firms may become multinational to keep domestic
customers that have moved abroad or to exploit financial market imperfections. These are
elaborated below.
SEARCH FOR RAW MATERIALS. Some firms become MNCs to exploit the raw materials that can be found
overseas, such as oil, coal, minerals, and other natural resources.
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, only in the postwar period have multinational
firms 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 MNC is characterized
more by attitude than the physical reality of an integrated, global system of marketing and
production activities. It involves looking beyond the boundaries of the home country and treating
the world as “our oyster.”
After stimulating student interest with this vision of the MNC, I then introduce the financial
decisions that MNCs 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)
that 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 “THE DEBATE OVER OUTSOURCING”
1. What are the pros and cons of outsourcing?
ANSWER. PROS: Outsourcing enables Americans to buy services less expensively abroad, increases
U.S. productivity, and enables U.S. companies to cut their costs while improving quality, time to
market, and capacity to innovate. It also allows the U.S. to use its comparative advantage in
financial, managerial, and technical services by specializing in and exporting such services as
higher-end computer programming, management consulting, engineering, banking,
telecommunications, and legal work.
CONS: As with any kind of trade, importing of services through outsourcing results in the loss of jobs
for Americans previously employed in providing those services. Outsourcing may also cause U.S.
companies that provide these services to go out of business.
2. How does outsourcing affect U.S. consumers? U.S. producers?
ANSWER. As the answer to part a) points out, outsourcing allows companies to buy services less
expensively abroad. Competitive pressures force companies to pass these savings along to
consumers in the form of lower-priced goods and services.
U.S. producers are able to boost productivity and cut costs while improving quality, time to market,
and capacity to innovate. As such, American companies are better able to compete. This
competition, however, forces companies to pass most of their savings from outsourcing through to
their customers.
3. Longer term, what is the likely impact of outsourcing on American jobs?
ANSWER. The longer-term effect of outsourcing on U.S. jobs should be insignificant. Trade has little,
if anything, to do with the quantity of jobs in an economy but rather the nature and distribution of
those jobs in various occupations. Outsourcing should lead to higher average productivity of those
jobs that Americans work at and, hence, to higher wages and benefits.
4. Several states are contemplating legislation that would ban the outsourcing of
government work to foreign firms. What would be the likely consequences of such
legislation?
ANSWER. Such legislation would result in less efficient and more expensive government. The end
result would be higher taxes or, if taxpayers balk, fewer government services.
SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONSNumber range CHAPTER
1. Explain how globalization may affect even a small business in your local area.
ANSWER. Globalization entails opening national borders to enable freer movement of goods and
services. Due to the rapid decrease in communication and transportation costs over the last few
decades, many firms find it cheaper to source products from foreign countries. Also, firms are now
aware of international market opportunities and locate their plants and facilities abroad. As a
, result, the competition faced by any business is now more global rather than merely local. A small
business in any local area now faces competition from both large MNCs and similarly situated
businesses that take advantage of their international experience as well as internationally sourced
products.
2. Opponents of globalization and outsourcing argue that locating manufacturing activities
abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather
than resulting in a net loss of jobs, employment has actually increased. Also, the average
wages of workers have increased. How would you account for this discrepancy between
what the critics say and what statistics reveal?
ANSWER. Globalization is a two-way street. While some U.S. firms locate their plants overseas,
several foreign companies have also invested in the U.S. economy and located their plants here. For
example, major foreign automobile manufacturers such as Toyota and BMW have set up
manufacturing plants in the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the
U.S. economy has experienced unprecedented productivity growth due to the increase in trade from
globalization. The net impact of this productivity growth as measured in output per hour has been
such as to increase the inflation-adjusted worker compensation. Thus, while critics of globalization
look at only one side of the picture and point to job losses due to outsourcing, they neglect to take
into account the job creation due to foreign investment in the U.S. and the increase in trade due to
globalization. Critics also ignore the fact the increased opportunities for trade due to globalization
result in high-value-added services being performed in the U.S. and the increase in productivity of
the U.S. worker. As a result, worker wages have also gone up.
3. Elaborate on the benefits of a proactive approach to globalization and global
competition.
ANSWER. Rather than react to globalization, firms benefit by facing globalization and global
competition head on. Globalization and global competition unleash the forces of creative
destruction, whereby new technologies and new methods of business force out poorly performing
competitors. To take advantage of the full potential of globalization and to counter global
competition, many firms adopt new technologies, improve production methods, explore new
markets, and introduce new and better products. The results of such improvements are clear in
terms of the lower prices and expanded choices for consumers. Thus, proactive firms stay ahead of
their competition by taking advantage of the various benefits of globalization and the expanded
trade opportunities.
4. What are the various reasons for the emergence of multinational firms?
ANSWER. The primary reason for the emergence of MNCs is the international mobility of several
factors of production. MNCs emerge to take advantage of globally available raw materials, markets,
specialized skills, and knowledge. Also, firms may become multinational to keep domestic
customers that have moved abroad or to exploit financial market imperfections. These are
elaborated below.
SEARCH FOR RAW MATERIALS. Some firms become MNCs to exploit the raw materials that can be found
overseas, such as oil, coal, minerals, and other natural resources.
