International Corporate Finance

This article focuses on how multinational corporations decide on whether or not to enter foreign markets and evaluate their performance once they have entered the markets. One of the main questions that the financial team will ask when contemplating whether or not it should go into foreign operations is "what are the benefits?" In order to evaluate its risk-return profile, the multinational corporation will review imperfections in the various markets for goods and services, factors of production, and financial assets that can be created. Two long run investment and financing options (i.e. international capital budgeting and direct foreign investments) are explored, and the results from a study conducted on the how to measure overseas financial performance are reviewed.

Keywords Capital Budgeting; Direct Foreign Investment (DFI); Discounted Cash Flow Techniques; International Business Operations; International Capital Budgeting; International Strategy; Multinational Corporation (MNC)

Finance > International Corporate Finance

Overview

One of the focal points for many multinational corporations is to have the ability to perform financial transactions outside of the United States. It is important for these corporations to have the ability to participate in the international trade process. Financial managers of multinational corporations must be aware of the financial techniques involved in the international trade process. Three basic needs of import-export financing are: Guarantee against the risk of a business deal being incomplete, security against foreign exchange dangers, and a way of financing the transactions involved (Eiteman & Stonehill, 1979). Some of the key banking services that are needed include letters of credit, wire transfers, collections, and foreign exchange (Teller Sense, 2003). It is important for organizations to have the ability to wire deposits in a timely manner, have the credibility for banks to provide a letter of credit on its behalf, and collect payments quickly and easily.

"Although the original decision to undertake operations in a particular foreign country may be determined in practice by a mix of strategic, behavioral, and economic decisions, the specific project and all reinvestment decisions should be justified by traditional financial analysis" (Eiteman & Stonehill, 1979, p. 264). One of the main questions that the financial team will ask when contemplating whether or not it should go into foreign operations is "what are the benefits?" In order to evaluate its risk-return profile, the multinational corporation will review imperfections in the various markets for goods and services, factors of production, and financial assets that can be created (Eiteman & Stonehill, 1979).

Application

Long-Run Investment & Financing

Two key areas of long term investments and financing are international capital budgeting and direct foreign investments. Although many large multinational corporations with international sales have been the focus of many capital budgeting studies, direct foreign investments are just as important when a multinational corporation is reviewing its long-run investment and financing options. Direct foreign investments deal with market imperfections and behavioral factors which may entice a multinational corporation to invest in a foreign country on a long term or permanent basis. International capital budgeting applies contemporary finance theory and special research into international operations to considerations of techniques by which foreign investment decisions should be made (Eiteman & Stonehill, 1979).

International Capital Budgeting

"Capital budgeting is a financial analysis tool that applies quantitative analysis to support strong management decisions" (Bearing Point, n.d.). Capital budgeting seeks to provide a simple way for the finance department to see the "big picture" of the benefits, costs and risks for a corporation planning to make short term and/or long term investments. Unfortunately, many of the leading methods have experienced problems, especially when an organization is using a standardized template. Examples of potential problems include:

• The benefits, costs, and risks associated with an investment tend to be different based on the type of industry (i.e. technology versus agricultural).
• A corporation may highlight the end results of the return on investment model and the assumptions that support the results versus a balanced analysis of benefits, costs, and risks.

If an organization does not account for the above-mentioned scenarios, there is a possibility for the results to be skewed, which would make the data unusable. This type of error could hinder a project from getting approved. Therefore, it is critical for financial analysts to have a more effective and efficient technique to use. Bearing Point (n.d.) identified several leading practices that organizations are using in order to avoid reporting faulty information. The theme in all of the techniques is that capital budgeting is not the only factor considered. Other quantifiable factors are utilized in order to see the big picture.

• Consider the nature of the request — The type of benefit obtained by the investment will determine the nature of the request. Therefore, it may be beneficial to classify the benefit types into categories such as strategic, quantifiable and intangible.
• All benefits are not created equal — Benefits should be classified correctly in order to properly analyze. There are two types of benefits — hard and soft. Hard benefits affect the profit and loss statement directly, but soft benefits do not have the same affect.
• Quantify risk — Make sure that the risks are properly evaluated. In most cases, risks are neglected. Also, it would be a good idea to build a risk factor into whatever model is utilized.
• Be realistic about benefit periods. Make sure that the expectations are realistic. In the past, corporations have created unrealistic goals for the benefits period by anticipating benefits to come too early and reusing models that reflect the depreciation period for the capital asset.

Although the same theoretical framework applies, capital budgeting analysis of a foreign product can be more complex than the domestic products. Eiteman and Stonehill (1979) identified eight potential complications for the international capital budgeting process. Potential problems included:

• There is a need to distinguish between project cash flows and parent cash flows.
• Financing and remittance of funds to the parent company need to be absolutely identified due to the conflicting tax systems, constraints on financial flows, local norms, and changes in financial markets and institutions.
• Differential rates of national inflation can be important in changing competitive positions and cash flows over time.
• Foreign exchange rate changes which are not matched by differential national inflation rates may alter the value of cash flows from affiliate to parent and vice versa.
• Segmented worldwide capital markets may initiate a chance for financial gain or could cause even more financial losses.
• Terminal value is hard to evaluate due to possible divergent market values of a project to potential buyers from the host, parent, or third countries.
• Political risks may drastically reduce the value of a foreign investment.

Direct Foreign Investment

Investment decisions must be made for both foreign and domestic endeavors. However, the process is more complex when evaluating foreign investment decisions. Foreign investments are usually made with a more complicated set of strategic, behavioral, and economic considerations. In addition, the evaluation phase tends to be longer, more costly, and results in less information on which to evaluate opportunities. Financial assessments of initial financial overseas investments that use the ordinary discounted cash flow technique are not considered as reliable as domestic investments because of larger perceptions based on corporate, political, and foreign exchange risks.

Strategic Considerations for Foreign Investments

Hogue (1967) was the first to introduce the concept that the motivation of multinational corporations is based on four types of strategic consideration when making decisions on direct foreign investments. The four types are market seekers, raw-material seekers, production-efficiency seekers, and knowledge seekers.

• Market seekers have a desire to produce in foreign markets in order to satisfy local demand or to export to markets in markets outside of their home market.
• Raw-material seekers focus on extracting raw materials wherever they can be found. They will either export their findings or process them for sale in the host country.
• Production-efficiency seekers produce in countries where one or more of the factors of production are under priced relative to their productivity.
• Knowledge seekers operate in foreign countries in order to gain access to technology or managerial experience. It should be noted that the four types of strategic considerations are mutually exclusive.

Methods for Multinational Investing

Given the complexities experienced by most multinational corporations when evaluating foreign investments, researchers in the field have indicated a need for a better way to evaluate the investments. One proposal was to establish operational foreign investment criteria that are consistent with the behavioral theory of the corporation. Stonehill and Nathanson (1968) conducted a survey to see what methods were utilized by organizations when making multinational financing investments. The researchers used Fortune's list and selected 219 American firms and 100 foreign firms. The results of their research revealed that: Most foreign and domestic investment alternatives use the same capital budgeting procedures, there was a difference in the way that organizations viewed foreign income, over 64 percent of the organizations did not vary cost or capital for foreign investments, nearly all of the organizations indicated that they made allowances for risk, and nearly all of the organizations consolidated majority owned foreign subsidiaries with domestic divisions.

Oblak and Helm (1980) conducted a similar study to see if there had been any significant changes since the study conducted by Stonehill and Nathanson. Their survey was sent to 226 Fortune 500 organizations which operated wholly owned subsidiaries in 12 or more foreign countries. There was a 26% response rate and the capital budgets of the respondent firms ranged from $10 million to $2 billion annually with a median of $200 million. The results of the survey indicated that multinational corporations conducted more detailed analyses of their foreign projects. Compared to the results found by Stonehill and Nathanson in 1966, Oblak and Helm reported that a higher percentage of multinational corporations used discounted cash flow methods and adjusted for risk in foreign project evaluations. However, the corporations had not made a significant change in the way in which they measured the returns from foreign projects or the determination of the appropriate discount rate.

Viewpoint

Overseas Financial Performance

International business strategy provides corporations the opportunity to expand and manage business operations in many locations across the world. Many organizations are weighing the pros and cons of starting operations overseas. However, it is imperative that the decision makers identify opportunities, explore resources, and assess core competencies before implementing a plan to move forward. These three factors may provide a foundation for many corporations as they implement an international strategy. According to Hoskisson, Hitt, and Ireland (2003), each factor should be evaluated when determining whether or not to move forward.

"In today's international environment of economic uncertainty and volatile markets, financial executives face a number of unique and challenging problems when seeking to evaluate the financial performance of operations outside of their home country" (Persen and Lessig, 1979, p. 5). Persen and Lessig (1979) conducted a study in order to identify and evaluate the methods and procedures that tend to be used by leading multinational corporations as they attempt to find answers to these problems. The study addressed specific ways in which overseas operations are evaluated, especially financial performance. It was found that most multinationals use more than one criterion when measuring the results of their operations. Some of the most common performance standards included: Sales unit growth, growth in earnings from operations, earnings from operations after tax, and three efficiency indicators (earnings from operations after tax return on net operating assets; earnings from operations after return on investment; and free cash flow rate of return on investment).

Three of the topics from the study that will be discussed in this article include principle evaluation techniques, foreign exchange considerations, and other external financial considerations.

• Principle Evaluation Techniques — According to the survey, the top four measurements were operating budget comparisons, contribution to earnings per share, return on investment, and contribution to corporate cash flow. Operating budget comparisons was ranked as the #1 choice among the respondents. It was found that large multinational corporations favored the "contribution to earnings per share" technique more so than smaller firms. It was found that the "return on investment" technique's popularity was growing as a leading measurement base. Oil and metal corporations tended utilize the contribution to corporate cash flow technique.
• Foreign Exchange Considerations — One of the areas in the evaluation process that tended to be ignored was how the multinational corporations dealt with results that are denominated in currencies other than the one used by the American parent company. "Most US companies doing a substantial volume of business overseas have been operating abroad for a number of years, and thus the matter of changing foreign exchange rates is nothing new. With the onset of more volatile fluctuations in recent years and new accounting developments (i.e. Financial Accounting Standards Board's Statement on translation accounting), this area has assumed a greater significance" (Persen & Lessig, 1979, p. 87-88). Most multinationals will deal with this issue in one of two ways. First, there may be the local company perspective. This perspective places emphasis on how well the local company performs in its own (foreign) environment and its own currency. The second approach is the parent company perspective. The emphasis is placed on how well the local unit is performing in terms of its contribution to the overall corporation in the parent's currency.
• Other External Financial Considerations — Although inflation was identified as the most significant external financial consideration, there were other concerns listed. Some of these areas included political instability, other government regulations, labor unions, differences in tax regulations, different accounting standards, language barriers, cultural differences, industrial democracy, and communications facilities. The survey asked the respondents what they considered to be the main difference between evaluating the financial performance of domestic and overseas operations. Although there were a variety of responses, most fell into five categories that could be broken down into two basic groups. One group dealt with the variety of currencies and inflation rates and the other group dealt with the financial atmosphere and local government regulations. The five categories reported were: Differences in currencies, exchange rate flux; translation of currencies; variances in inflation rates; variation in financial and economic conditions; and multiplicity of government regulations and controls.

Conclusion

One of the focal points for many multinational corporations is to have the ability to perform financial transactions outside of the United States. It is important for these corporations to have the ability to participate in the international trade process. Some of the key banking services that are needed include letters of credit, wire transfers, collections, and foreign exchange (Teller Sense, 2003). It is important for organizations to have the ability to wire deposits in a timely manner, have the credibility for banks to provide a letter of credit on its behalf, and collect payments quickly and easily.

"Although the original decision to undertake operations in a particular foreign country may be determined in practice by a mix of strategic, behavioral, and economic decisions, the specific project and all reinvestment decisions should be justified by traditional financial analysis" (Eiteman and Stonehill, 1979, p. 264). One of the main questions that the financial team will ask when contemplating whether or not it should go into foreign operations is "what are the benefits?" In order to evaluate its risk-return profile, the multinational corporation will review imperfections in the various markets for goods and services, factors of production, and financial assets that can be created (Eiteman & Stonehill, 1979).

"In today's international environment of economic uncertainty and volatile markets, financial executives face a number of unique and challenging problems when seeking to evaluate the financial performance of operations outside of their home country" (Persen & Lessig, 1979, p. 5). Persen and Lessig (1979) conducted a study in order to identify and evaluate the methods and procedures that tend to be used by leading multinational corporations as they attempt to find answers to these problems. The study addressed specific ways in which overseas operations are evaluated, especially financial performance. Three of the topics discussed in this article are principle evaluation techniques, foreign exchange considerations, and other external financial considerations.

As more financial institutions begin to participate in the global economic system, process improvement has led to the reduction of communication and information costs as a result of technology (Baldwin & Martin, 1999). "One variable that has been used in the international finance literature to proxy information costs is the (geographical) distance between two markets" (Buch, 2005, p. 787). Many have attempted to determine if there is a correlation between international asset holding and distance. Unfortunately, there has not been much research on the effect of distance on international financial relationships over a period of time. Although researchers (Portes & Rey, 2001) have found that some investors have a preference for doing business in surrounding markets with substantial business cycle correlations, Petersen and Rajan (2002) reported that there has been an increase in the business being conducted between banks and their credit buyers. What is important is the fact that international banking is a key factor in the way organizations, such as multinationals, conduct their business.

Terms & Concepts

Capital Budgeting: The process of weighing the cash flows with rates of return to determine what types of long-term projects are worth investing in.

Direct Foreign Investment (DFI): A corporation in one country that makes a financial and physical investment in the creation of a factory in a different country.

Discounted Cash Flow Techniques: A tool and method used to analyze and evaluate the income capitalization approach to value.

International Business Operations: When projects are located in host countries other than the home country of the multinational corporation.

International Capital Budgeting: The process of running a company in order to produce value for those who own shares of the stock.

International Strategy: An organization's attempt to instill value in its company by relocating some of its core competencies to overseas markets where there is higher need for such competencies.

Multinational Corporation (MNC): A corporation that has its facilities and other assets in at least one country other than its home country.

Bibliography

Aliber, R. (1979). Exchange risk and corporate international finance. London: The MacMillan Press.

Baldwin, R., & Martin, P. (1999). Two waves of globalization: Superficial similarities, fundamental differences. In H. Siebert (ed.), Globalization and Labor, Tubingen: Mohr Siebeck.

Bearing Point (n.d.). Improve your capital budget techniques. Retrieved July 9, 2007, from http://office.microsoft.com/en-us/help/HA011553851033.aspx

Brealey, R. A., Cooper, I. A., & Kaplanis, E. (2012). International propagation of the credit crisis: Lessons for bank regulation. Journal of Applied Corporate Finance, 24, 36-45. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84484549&site=ehost-live

Buch, C. (2005). Distance and international banking. Review of International Economics, 12, 787-804. Retrieved July 5, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18257877&site=bsi-live

Eiteman, D., & Stonehill, A. (1979). Multinational business finance, (2nd edition). Reading, MA: Addison-Wesley Publishing Company.

Hogue, W. (1967, December 29). The foreign investment decision making process. Association for Education in International Business Proceedings.

Hoskisson, R., Hitt, M., & Ireland, R. (2003, January). International strategy. Retrieved on May 22, 2007, from http://jobfunctions.bnet.com/presentation.aspx?&docid=92164&promo=110000

Lucey, B. M. (2012, March). Perspectives on international and corporate finance. Journal of Banking & Finance. p. 625. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=71335363&site=ehost-live

Matoussi, H., & Jardak, M. (2012). International corporate governance and finance: Legal, cultural and political explanations. International Journal of Accounting, 47, 1-43. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=73825376&site=ehost-live

Oblak, D., & Helm Jr., R. (1980). Survey and analysis of capital budgeting methods used by multinationals. Financial Management (1972), 9, 37-41. Retrieved July 5, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5031602&site=bsi-live

Persen, W., & Lessig, V. (1979). Evaluating the financial performance of overseas operations. New York: Financial Executives Research Foundation.

Petersen, M., & Rajan, R. (2002). Does distance still matter? The information revolution in small business lending. Journal of Finance, 57, 2533-2570.

Portes, R., & Rey, H. (2001). The determinants of cross-border equity flows. Center for International and Development Economics Research, University of California, Department of Economics, Berkeley, CA.

Stonehill, A., & Nathanson, L. (1968). Capital budgeting and the multinational corporation. California Management Review, 10, 39-54. Retrieved July 5, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5045314&site=bsi-live

Suggested Reading

Bliss, C., Clark, P., Oppenheimer, P., Tyson, L., & Williamson, J. (1981). Exchange risk and corporate international finance/The financing procedures of British foreign trade/money in international exchange. Journal of International Economics, 11, 123-129. Retrieved September 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5018405&site=bsi-live

Dince, R. (1980). Exchange risk and corporate international finance (Book Review). Southern Economic Journal, 47, 247-249. Retrieved September 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4626331&site=bsi-live

Rugman, A. (1980). Internalization theory and corporate international finance. California Management Review, 23, 73-80. Retrieved September 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4760051&site=bsi-live