Financial Management in Multinational Organizations and would need to describes how multinational organizations use the financial management practices,

Financial Management in Multinational Organizations and would need to describes how multinational organizations use the financial management practices,

Introduction

A multinational company is a company that operates across multiple countries. Like domestic companies, multinational businesses must design and implement financial management strategies that are consistent with the creation of shareholder value (Holburn et al, 2010). Multinational financial management is far more difficult compared to traditional financial management owing to the additional challenges that arise because of the operation across other countries (Jimenez, 2010). Multinational companies for example are exposed to foreign exchange risk, political risk, and many other challenges. In order to overcome these challenges, multinational companies must design and implement appropriate financial management strategies (Jimenez, 2011). This paper aims at looking at financial management in a multinational business. The paper will be looking at foreign exchange exposure, political risk, capital budgeting and capital structure.

Foreign Exchange Exposure

Foreign exchange exposure is the impact of fluctuations of exchange rates on the net cash flows of a multinational firm (Shapiro, 2006). Multinational firms are exposed to fluctuations in exchange rates because they operate across many countries and as such interact with many currencies. Changes in currency exchange rates therefore have a significant effect on the net cash flows of a firm. Changes in foreign exchange rate can have positive and negative effects (Bonardi et al, 2006). Multinational financial management is principally concerned with eliminating the negative impact of changes in foreign exchange rates on the net cash flows of a multinational firm. Foreign exchange exposure is therefore the risk that a foreign currency may move in a direction that has undesirable financial consequences on a multinational business (Shapiro, 2006). For example, Nike reported in its 2005 Annual Report and Accounts that its international operations and sources of supply were subject to the usual risks of conducting business in foreign countries such as changes in currency values (Holburn and Zelner, 2010). Starbucks reports that the 32% increase in its international sales in 2004 can be partly attributed to declines in the value of the U.S dollar against the Canadian dollar the Great British Pound (Holburn and Zelner, 2010). Furthermore, McDonalds reported in 2000 that its results were negatively affected by a weak euro, British Pound and Australian dollar (Holburn and Zelner, 2010).

According to Shapiro (2006), MNCs are exposed to three types of exposure. These include:

Transaction exposure;
Economic exposure; and
Translation exposure.

Transaction Exposure

Transaction exposure is the exposure of the multinational firm’s cash flows to fluctuations in foreign exchange rates, which can be attributed to the firm’s foreign-currency denominated transactions (Shapiro, 2006).

Economic Exposure

Economic exposure arises from the MNC’s future and unknown foreign currency-denominated transactions. This occurs because of the MNC’s long-term involvement in a particular foreign market (Shapiro, 2006).

Translation Exposure

Translation exposure is the exposure of the value of the MNC’s assets, liabilities, revenues and expenses to changes in foreign exchange rates (Shapiro, 2006). In other words, it is exposure of balance sheet and income statement items to changes in foreign exchange rates. This exposure is particularly important for MNCs with a physical presence in a foreign country (Eiteman et al, 2007).

Managing Exposure to Foreign Exchange Rate Risk

According to Eiteman et al (2007), MNCs can manage their exposure to foreign exchange rate risk by designing appropriate hedging strategies. The hedging strategy depends on whether the MNC is dealing with transaction, economic or translation exposure.

Transaction exposure can be hedged through the use of currency derivatives such as forward and futures currency contracts. In addition, transaction exposure can be managed using forward market hedges.

A forward contract is an agreement between two knowledgeable willing parties in which one of the parties agrees to pay a fixed amount of foreign currency at a specified future date (Buckley, 2004). Forward contracts can be used by MNCs to hedge against fluctuations in foreign exchange rates because they enable the MNC to convert the uncertain future home currency values of its assets or liabilities into certain home currency values to be received or paid on the specified future date regardless of what happens to the exchange rate (Fabozzi et al, 2009).

Like forward contracts, futures contracts represent agreements to pay or receive a fixed amount of foreign currency at a specified future date (Buckley, 2004). The main difference between forward and future contracts is that futures contracts are standardized and traded on organized exchanges while forward contracts are unstandardized contracts between two individuals. Hillier et al (2010) note that as a result of this feature, futures contracts have no default risk while forward contracts suffer from high default risk. Like forward contracts, futures contracts provides MNCs with a means of converting uncertain future home currency values into certain home currency values. The disadvantage of using futures contracts to hedge is that they are limited in supply (Madura and Fox, 2007). This limitation means that MNCs may find it difficult to buy a sufficient number of contracts to hedge against a given level of exposure. Therefore, the MNC may find it wise to combine futures and forward contracts.

MNCs can also manage transaction exposure by using a money market hedge. A money market hedge is a synthetic forward contract. The money market hedge is based on the covered interest parity theorem, which states that the forward price must be exactly equal to the current spot exchange rate multiplied by the ratio of the riskless interest rates of the currencies in question (Watson and Head, 2006). An MNC that has an agreement to pay foreign currency at a specified future date can ascertain the present value of the foreign currency obligation at the foreign lending rate and convert the appropriate amount of home currency taking into account the current sport exchange rate (Eiteman et al, 2007). By so doing, the MNC converts the obligation into a home currency payable thereby eliminating all the exchange rate risk. In like manner, an MNC that has an agreement to receive foreign currency at a specified future date can ascertain the present value of the foreign currency receipt using the borrowing rate of the foreign currency and convert this present value into a home currency at the current spot exchange rate (Bonardi et al, 2006).

Transaction exposure can also be hedged through the use of currency options (Jimenez, 2010). These are contracts that have an upfront fee and give the owner the right but not the obligation to trade domestic currency for foreign currency and vice versa in a specified quantity at a specified price over a specified period. There are two main types of options including currency put option and currency call options. Currency options can be used by MNCs to eliminate the foreign exchange rate risk (Hillier et al, 2010). Currency options are advantageous over forwards, futures, and money market hedges in that they allow for the removal of downside risk without limiting the ability of the MNC to benefit from upside risk.

Political Risk

In addition to foreign exchange rate risk, multinational firms are exposed to political risk, which requires the design and implementation of appropriate financial management strategies.

Political risk is the risk that balance sheet values of the MNC may be adversely affected by changes in government policies (Moles and Terry, 2005). Political risk is often regarded as expropriation. However, it is not limited to expropriation. In addition to expropriation, political risk can be expanded to include civil unrest, war, restrictions on remittance of profits, foreign or domestic currency, price controls, fiscal changes, cancellation of contracts, etc (Shapiro, 2006). Political risk has a significant impact on MNCs because of the location of their operations in foreign countries (Shapiro, 2006).

Political risk is a threat to MNCs because of opportunistic behavior by governments (Henisz, and Zelner, 2001). It is a function of the bargaining power of MNCs relative to that of the government. MNCs become more vulnerable to expropriations, unilateral modifications of agreements and nationalizations when bargaining power shifts from MNCs to the government (Jumenez, 2011). On the contrary, political risk will be lower if the bargaining power of MNCs is higher than that the government. MNCs may suffer from lower bargaining power because of high sunk costs (Jimenez, 2011). However, from the view point of political institutions, the shift in bargaining power can be attributed to greater political discretion on the part of the authorities arising from lack of restrictions on their behaviour (Henisz and Zelner, 2001).

Having defined political risk and its potential impact on MNCs, the remainder of this section will focus on how MNCs can manage it. It has been argued that political risk cannot be treated exclusively as an exogenous variable. It is at least partially an endogenous variable (Jimenez, 2010). This indicates that MNCs can overcome or manage political risk by designing and implementing appropriate political risk management strategies. One of these strategies is to target the market and non-market environment with an increasing focus on the political context (Bonardi et al., 2006; Oliver and Holzinger, 2008).

MNCs can also manage political risk by developing capabilities that enable them to interact with the authorities of the host country in more appropriate ways to achieve their strategic objectives (Boddewyn and Brewer, 1994; Fleet and Cory 2002; Wan, 2005). Empirical evidence suggests that MNCs with greater political capabilities are often in a better position to develop and implement proactive political risk management strategies, which enable them to gain competitive advantage in host countries with higher levels of political risk or unpredictable policy contexts (Jimenez, 2013). The management of political risk by MNCs in the U.S electricity sector has been consistent with this evidence (e.g., Holburn and Zelner, 2010). Similar evidence has been found for the European air transport sector (e.g., Lawton and Rajwani, 2011; Lawton et al., 2013), as well as for MNCs in Spain (e.g. Jimenez, 2010) and in FDI flows from Southern Europe to Northern Africa (e.g., Jimenez, 2011).

Capital Budgeting

MNCs employ the same capital budgeting approaches employed by domestic firms. The main focus of MNCs is on the cash inflows and outflows associated with the prospective long-term investment projects (Madura and Fox, 2007).

MNC capital budgeting begins with an identification of the initial capital required for the project. The next step is to estimate the future cash inflows and outflows over the investment horizon as well as the estimation of the terminal or scrap value of the investment. The next step is to determine the discount rate to use in valuing the cash flows and the last step is to apply a traditional capital budgeting decision criteria such as the NPV, the IRR, the payback period, or the adjusted present value (APV) (Shapiro, 2006).

While the capital budgeting approach is basically the same as that of domestic firms, there are specific issues that the MNC needs to consider. The MNC must distinguish between the cash flows of the parent company from those of specific projects. The parent cash flows are determined by the form of financing. Additional cash flows generated by a new investment in one subsidiary may be partly or wholly transferred to another subsidiary (Watson and Head, 2006).

Hillier et al (2010) also argue that the MNC must also take into account specific issues that affect the remittance of funds from the foreign country to the home country such as differing tax systems, legal and political constraints on the investment of funds, local business norms, and differences in the manner in which financial markets and institutions operate across different countries.

The MNC must also consider an array of non-financial payments, the impact of unexpected changes in currency exchange rates, the use of segmented national capital markets, the use of host-government subsidized loans, political risk and the identification of terminal value (Fabozzi et al, 2009).

From the perspective of the parent, only the cash flows to the payment should be considered. These cash flows form the basis for stock dividends, reinvestment elsewhere in other countries, repayment of corporate-wide debt, and other purposes that can different stakeholders of the firm. MNC capital budgeting often violates a cardinal rule of capital budgeting, which states that financial cash flows should be kept separate from operating cash flows (Buckley, 2004).

MNCs should not invest in foreign projects unless there is ample evidence that the risk-adjusted return of the foreign project is greater than the return that locally-based competitors can earn. If MNCs are unable to earn superior profits on foreign investments, shareholders would find it more profitable to buy shares in local firms. Projects should be evaluated from the perspective of the project and parent view. By so doing, the MNC will be better placed to evaluate the viability of the project and whether it is better than locally-based projects.

Conclusions

This paper has discussed financial management from the perspective of the multinational organization. The study can conclude that unlike domestic firms, multinational firms face greater financial risk which arises as a result of their foreign involvement. Therefore, multinational firms need to implement additional financial management strategies. For example, multinational companies face significant exposure to foreign exchange rate risk and political risk. These risks call for special financial management techniques on the part of the multinational company. The risks also call for additional steps in capital budgeting for MNCs.

Recommendations

Based on the above conclusions, this paper recommends that MNCs should put in place strategies to identify the different financial risks that are inherent in foreign markets. Special attention should be paid to currency fluctuations and their potential impact on the value of d the firm. To adequately address foreign exchange rate risk, the MNC should put in place strategies to measure risk and its impact on firm value. Only after measuring the impact can adequate strategies be developed and implemented. The MNC should also put in place strategies to measure and manage political risk. Countries with significant high levels of political risk should be avoided.

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