739IBF International Business Finance Topic 1

Topic 1:
International financial management and trade
Businesses evolve into multinational corporations (MNCs) so that they can capitalise on
international opportunities. Financial managers must be able to assess the international
environment, recognise opportunities, implement strategies, assess exposure to risk and
manage that risk.

In this topic, important international financial management and trade theories are examined
which assist in explaining why firms may become motivated to expand internationally. These
are (1) the theory of comparative advantage, (2) the imperfect markets theory, and (3) the
product cycle theory (Madura 2015, p. 8). How firms engage in international business is
then discussed, including methods such as international trade, licensing and franchising. The
topic then discusses important factors affecting international trade flows between countries,
such as the cost of labour, inflation, national income, credit conditions, government policies
and exchange rates. Many multi-national corporations are engaged in direct foreign
investment. This is responsible for a significant proportion of international capital flows.
Consideration will therefore be given to factors affecting direct foreign investment, portfolio
investment and the impact of international capital flows. Finally, the topic will describe the
key international agencies that have been established to facilitate international trade and
international transactions.

This topic contains the following parts:

Why firms pursue international business

How firms engage in international business
Factors affecting international trade flows
International capital flows
Agencies that facilitate international flows

Learning resources

Chapters 1 (sections 12, 13) and 2 (sections 23, 24 and 25) of the textbook: Madura, J
2015, International financial management, 12th edn, Cengage Learning, Stamford, USA.

Key terms and concepts

- Theory of comparative advantage - International capital flows

- Imperfect markets theory - Direct foreign investment
- Product cycle theory - Portfolio investment
- International trade - International financial agencies
- Licensing, franchising - Exchange rates
- Joint ventures - Determinants of international trade
- Foreign subsidiaries

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Part 1: Why firms pursue international business

There are three main theories which help to explain why firms engage in international
business. They are the (1) theory of comparative advantage, (2) the imperfect markets
theory, and (3) the product cycle theory (Madura 2015, p. 8). These theories serve to
complement each other in developing an understanding of the reasons for the growth of
international business activities (Madura 2015, p. 8).

An important reason for the growth in multinational business over time is due to firms
realisation that specialisation by countries can increase production efficiency (Madura 2015,
p. 8). The principle of comparative advantage states that a good should ideally be produced
by the country that has a smaller opportunity cost of producing that good. Because Japan
has a comparative advantage in producing cars compared with Australia, Japan should
produce more cars than it needs for its own use and export some of these to Australia.
Similarly, because the opportunity cost of producing certain minerals is less for Australia
than Japan, Australia has a comparative advantage in the production of minerals. Australia
will therefore produce more minerals than it wants to consume, and export some to Japan
and other countries, where the opportunity cost of mineral production is higher. Therefore,
trade between countries is an important result of differing levels of comparative advantage
between countries. Multi-national corporations (MNCs) often locate in particular countries
to take advantage of particular comparative advantages, such as cheaper labour, that cannot
be transported easily.

If markets were perfect then factors of production (such as labour) and other resources
would be easily transferable between countries (Madura 2015, p. 8). Because markets are
imperfect and factors of production are somewhat immobile, comparative cost advantages
can exist between international markets (Madura 2015, p. 8). This provides an incentive for
firms to seek out foreign opportunities and capitalise on a countrys particular resources
(Madura 2015, p. 8). MNCs such as Nike often [attempt to] capitalise on a foreign
countrys particular resources (Madura 2015, p. 8).

According to the product cycle theory, demand for a product from foreign markets is likely
to be first met by the local firm exporting to these markets. However, as the demand from
overseas markets is maintained, or growing, a firm is likely to consider locating in foreign
markets to maintain and build its competitive advantage. To deter competitors emerging in
foreign markets, the firm may then pursue strategies which aim to diversify the product by
adding refinements, or by packaging and marketing campaigns.

Textbook

You should read pages 89 of the textbook. Note the importance of the theory of
comparative advantage. The main justification for the imperfect market theory is based on
the reality that markets are imperfect and hence factors of production are not easily
transferable between countries. In the case of the product cycle theory, firms establish in
foreign markets to maintain a competitive advantage in these markets.

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739IBF International Business Finance Topic 1

Activity 1.1

Complete question 2 (part a) on page 23 of the textbook (Madura 2015): Explain how the
theory of comparative advantage relates to the need for international business.
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Activity 1.2

Complete question 3 (part a) on page 23 of the textbook (Madura 2015, p. 23): Explain how
the existence of imperfect markets has led to the establishment of subsidiaries in foreign
markets?
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Part 2: How firms engage in international business

Firms utilise a variety of entry strategies to gain access to foreign markets. These strategies
differ in terms of the risk, the control and commitment of resources they require and the
potential return on investment. There are two major types of entry. The first is the non-
equity method. This includes export and contractual agreements. The second is the direct
investment, equity method. This includes joint ventures and wholly owned subsidiaries. The
lowest level of risk is associated with the first method. The highest risk, but also the highest
potential for expected return on investment, is associated with the second method.

The first and the most common strategy of firms engaging in international business is for a
firm to become involved in the international trade of goods and services. In the case of
direct exporting, the firm becomes directly involved in marketing its products and services in
foreign markets.

Licensing involves a firm providing the licensee with patent rights, trademark rights,
copyrights or technology with respect to products and processes. In return, the licensee
agrees to produce the licensors products, market these products in an assigned territory
and pay the licensor fees and royalties usually related to the sales volume of the products.
This type of agreement is generally welcomed by foreign governments as a means of

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attracting new technology to a country. Licensing is often considered as a means of

conducting international business with a limited degree of risk.
Franchising is similar to licensing. However, the franchising organisation is often more
heavily involved in the development and control of the marketing programme. In this
arrangement, business owners (franchisees) pay fees and royalties to a parent company
(franchisor) in return for the right to become identified with its trademark, sell its products
or services, and often to utilise its business systems. Franchising usually has the advantages
of low political risk and allows for the simultaneous expansion into different regions.

In joint-venture arrangements, the international firm has an equity position and access to
management decision making in the foreign firm. This type of arrangement gives the
international firm a higher degree of control over operations and access to local market
knowledge. In addition, firms often acquire existing operations of firms in foreign countries
as a strategy for entering foreign markets. In this arrangement, the international firm makes
a direct investment in a production unit in a foreign market.

There are two primary methods for direct investments. Firms can make a direct acquisition
in the foreign market or they can develop their own facilities from scratch. Acquisition has
become a popular mode of entering foreign markets mainly due to the speed. - In addition,
acquisition is likely to involve a lower risk than constructing and developing operations from
the beginning, as the outcomes of an acquisition can be estimated more easily and precisely.

Textbook

While studying this part, you should read pages 913 of the textbook. Note the main
methods firms use to conduct international business and the relevant examples. These are
strategies designed essentially to penetrate foreign markets. Note also how particular
strategies may involve the promise of higher growth, but also entail higher risk.

Activity 1.3

Complete question 4 (part a) on page 23 of the textbook (Madura 2015): Do you think that
the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which
alternative is likely to have more risk?
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Activity 1.4

Complete question 5 (part b) on page 23 of the textbook (Madura 2015): Offer your opinion
on why the Internet may result in more international business.
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Part 3: Factors affecting international trade flows

The following are the most important factors that can influence international trade flows:

cost of labour
inflation
national income
credit conditions
government policies, and
exchange rates (Madura 2015, p. 42).

Labour costs differ, sometimes substantially, between countries. For example, workers in
China earn far less than most countries in Europe, North America and Australia. Firms where
labour costs are lower, have a comparative advantage in labour intensive industries when
competing globally.

If a countrys inflation rate increases relative to trading partners, then consumers and
corporations will most likely purchase more goods overseas and exports to other
countries will decrease (Madura 2015, p. 42). If a countrys national income increases by a
higher percentage than other countries, then it is likely that as the income level rises,
more imports will be purchased (Madura 2015, p. 43).

Credit conditions offered by banks tend to tighten when economic conditions weaken
(Madura 2015, p. 43). Banks become less willing to provide financing to MNCs, leading to a
reduction in corporate spending on imports (Madura 2015, p. 43).

Government policy through trade agreements, for example, can have a major influence on
the home countrys unemployment level, income level and economic growth (Madura
2015, p. 43). Governments may also impose trade restrictions, such as tariffs or quotas.
These have a substantial impact on trade flows between countries. Additional government
policies in the areas of environmental restrictions, subsidies for exporters, labour laws,
taxation, business laws or laws relating to security, may also have an important influence on
trade flows between countries.

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Madura (2015, p. 47) states that:

Each countrys currency is valued in terms of other currencies through the use of
exchange rates. Currencies can then be exchanged to facilitate international
transactions. The values of most currencies fluctuate over time because of market
and government forces.
If a countrys currency starts to rise in value against other currencies then goods exported
by that country become more expensive and exports tend to fall (Madura 2015, p. 48). On
the other hand imports are likely to become relatively cheaper, and are likely to increase.

As a result, exchange rates may be used to correct a balance of trade deficit in a particular
country. For example, if imports into the home country are relatively high compared to
exports, downward pressure is likely to be placed on the home currencys exchange rate.
Once the countrys home currencys value declines, the result should be more exports and
less imports (Madura 2015, p. 49). However, this result will depend on additional factors
including whether foreign companies lower their prices to remain competitive, or the fact
that a countrys currency need not weaken against all currencies at the same time (Madura
2015, p. 49). In addition, there is likely to be a time lag between a weakening currency and
changes in purchasing behaviour. This is because exporters and importers are committed by
contract to international transactions according to particular exchange rates they have
arranged, often in to the future. This time lag has been estimated to be around 18 months.

It is important to recognise that government policy which is aimed at influencing exchange

rates between countries can result in international friction. For example, it is often claimed
by US exporters that the value of the Chinese yuan is maintained at an artificially low level
against the [US] dollar (Madura 2015, p. 50). It is argued by some that if the Chinese yuan is
revalued upward the US exports [to China] would increase and US imports would decrease
and more US jobs could be created (Madura 2015, p. 50).

Textbook

You should read pages 4251 of the textbook. It is important to note how international trade
can significantly affect a countrys economy. It is therefore important to identify the main
factors that can affect international trade flows. Within such factors, government policies
can be particularly influential.

Activity 1.5

Complete question 3 on page 58 of the textbook (Madura 2015): How can government
restrictions affect international payments among countries?
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Activity 1.6

Complete question 2 (part a) on page 58 of the textbook (Madura 2015): How would a
relatively high home inflation rate affect the home countrys current account, other things
being equal?
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Part 4: International capital flows

Capital flows, or the movement of money, between countries has become increasingly
important along with growing international business operations. One of the most important
types of capital flows is direct foreign investment (Madura 2015, p. 51). Direct foreign
investment (DFI) involves a firm from one country making an investment to purchase a
physical asset, such as a factory, or building in another country. Firms commonly attempt to
engage in direct foreign investment so that they can reach additional consumers or utilise
low-cost labour (Madura 2015, p. 51).

A number of factors can affect the level of direct foreign investment between countries. This
includes: changes in government restrictions, privatisation by national governments, the
potential economic growth of a country, tax rates and exchange rates. For example, many
countries have lowered their restrictions on direct foreign investment since the 1990s and
have also engaged in privatisation of government assets. As a result, foreign firms can
acquire operations sold by national governments. Countries that have greater potential for
economic growth are more likely to attract DFI... Countries that impose relatively low tax
rates...are more likely to attract DFI (Madura 2015 p. 52). Firms are also likely to pursue DFI
in countries which have weaker currenciesespecially if the foreign currency is expected to
strengthen in the future. This enables home companies to purchase assets in the foreign
country when the foreign countrys currency is relatively weak. Hence foreign assets can be
purchased with a lower amount of home currency.

Firms may also engage in international portfolio investment, which will result in capital flows
between countries. International portfolios allow firms to diversify their assets by moving
away from a domestic-only portfolio. Foreign investors are particularly attracted to home
country financial markets when the interest rate in the foreign country is substantially lower
than that of the home country. In addition, investors normally prefer to invest in a country
where the taxes on interest or dividend income from investments are relatively low
(Madura 2015, p. 52).

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Madura (2015, p. 52) explains that:

When investors invest in a security in a foreign country, their return is affected by (1)
the change in the value of the security and (2) the change in the value of the currency
in which the security is denominated. If a countrys home currency is expected to
strengthen, then foreign investors may be willing to invest in the home countrys
securities in order to benefit from the currency movement.

A country such as the US relies heavily on foreign capital first, through direct investment
in factories and buildings (Madura 2015, p. 52). Second, according to Madura (2015, pp. 52
53):
foreign investors purchase US debt securities issued by US firms, and thereby serve
as creditors to US firms. Third, foreign investors purchase [US government] Treasury
debt securities and serve as creditors to the US government.

Textbook

You should read pages 5154 of the textbook. It is important to note that international
capital flows are made up of (1) direct foreign investment, and (2) international portfolio
investment. Many countries such as the US rely heavily on foreign capital.

Activity 1.7

Complete question 12 (part a) on page 59 of the textbook (Madura 2015): Assume that the
dollar is presently weak and is expected to strengthen over time. How will these
expectations affect the tendency of U.S. investors to invest in foreign securities?
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Part 5: Agencies that facilitate international flows

A number of agencies have been established to encourage international trade and

international financial transactions. Toward the end of the Second World War, the United
Nations held a major conference at Bretton Woods, New Hampshire to develop a structured
international monetary system; as a result the International Monetary Fund (IMF) was
formed (Madura 2015, p. 54).

The main objectives of the IMF according to Madura (2015, p. 54):

are to (1) promote cooperation among countries on international monetary issues,
(2) promote stability in exchange rates, (3) provide temporary funds to member

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countries attempting to correct imbalances in international payments, (4) promote

free mobility of capital funds across countries, and (5) promote free trade.

The IMF typically specifies economic reforms that a country must satisfy in order to receive
IMF funding (Madura 2015, p. 55). Some governments have failed to implement these
required reforms (Madura 2015, p. 55).

The International Bank for Reconstruction and Development (IBRD) was established in 1944.
It is also known as the World Bank. The World Bank provides financial and technical
assistance to emerging market countries. The World Bank consists of two development
finance institutions the International Bank for Reconstruction and Development (IBRD) and
the International Development Association (IDA), owned by 186 member countries.

The World Bank provides loans to credit worthy countries at market interest rates. In the
past, this usually occurred when they were in danger of sovereign debt default, which was
often a result of overspending and extensive borrowing. Many countries then devalued their
currencies, which resulted in hyperinflation. To combat this, the Bank often required
austerity measures, where the country was required to agree to cut back on spending and
support its currency. The World Bank loans are usually to invest in education, health, and
infrastructure. The loans can also be used to modernise a country's financial sector,
agriculture, and natural resources management.

The World Trade Organisation (WTO) was established in 1993 as a result of the final round of
the General Agreement on Tariffs and Trade (GATT) negotiations, called the Uruguay Round.
The WTO is responsible for monitoring national trading policies, handling trade disputes, and
enforcing the GATT agreements, which are designed to reduce tariffs and other barriers to
international trade and to eliminate discriminatory treatment in international commerce.
Unlike GATT, the WTO is a permanent body with the power to mediate trade disputes
between member countries and assess penalties.

The International Financial Corporation (IFC) commenced in 1956. IFC fosters sustainable
economic growth in developing countries by financing private sector investment, mobilising
capital in the international financial markets, and providing advisory services to businesses
and governments. IFC aims to assist companies and financial institutions in emerging
markets, create jobs, generate tax revenues, improve corporate governance and
environmental performance, and contribute to their local communities.

The International Development Association (IDA) is part of the World Bank that assists the
worlds poorest countries. Established in 1960, IDA aims to reduce poverty by providing low
interest loans (called credits) and grants for programs that boost economic growth, reduce
inequalities, and improve peoples living conditions.

Established in 1930, the Bank for International Settlements (BIS) is the world's oldest
international financial organisation. The BIS has 60 member central banks, representing
countries from around the world that together make up about 95% of world GDP. The
mission of the BIS is to serve central banks in their pursuit of monetary and financial

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stability, to foster international cooperation in those areas and to act as a bank for central
banks.

The Organisation for Economic Co-operation and Development (OECD) provides a forum in
which member governments can work together to share experiences and seek solutions to
common problems. The OECD works with governments to gain a better understanding of the
main drivers of economic, social and environmental change. There are several other
agencies whose objectives relate to economic development and who are focussed on
regional economies. These include the Asian Development Bank, Inter-American
Development Bank (focussed on the needs of Latin America) and the African Development
Bank. In 1990, the European Bank for Reconstruction and Development was created to help
Eastern European countries adjust from communism (Madura 2015, p. 57).

Textbook

You should read pages 5457 of the textbook. Note that these agencies have been
established to facilitate international trade and international financial transactions between
countries.

Activity 1.8

Complete question 4 on page 58 of the textbook (Madura 2015):

a. What are the major objectives of the IMF?

b. How is the IMF involved in international trade?

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Conclusion

In this topic we looked at five introductory issues important for international financial
management and trade. This included an examination of the main theories that have been
put forward to explain why firms pursue international trade. How firms engage in
international business was then discussed. Important factors affecting international trade
and capital flows were then considered. Finally, the main international agencies that have
been established to facilitate international flows between countries were examined.

Reference

Madura, J 2015, International financial management, 12th edn, Cengage Learning, Stamford,
USA.

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Feedback about activities

Activity 1.1

Complete question 2 (part a) on page 23 of the textbook (Madura 2015): Explain how the
theory of comparative advantage relates to the need for international business.

The theory of comparative advantage implies that countries should specialise in production,
thereby relying on other countries for some products. Consequently, there is a need for
international business. Madura (2015, p. 8) explains that:
Many of the Virgin Islands, for example, specialise in tourism and rely completely on
international trade for most products. Although these islands could produce some
goods, it is more efficient for them to specialise in tourism. That is, the islands are
better-off using some revenues earned from tourism to import products, than
attempting to produce all the products they need.

Activity 1.2

Complete question 3 (part a) on page 23 of the textbook (Madura 2015, p. 23): Explain how
the existence of imperfect markets has led to the establishment of subsidiaries in foreign
markets?

Because of imperfect markets, resources cannot be easily and freely obtained by the MNC.
Consequently, the MNC must sometimes locate in close proximity to resources. If markets
were perfect then factors of production (such as labour) and other resources would be
easily transferable between countries (Madura 2015, p. 8). This would create equality in
both costs and returns and thus would remove the comparative cost advantage, which is the
rationale for international trade and investment (Madura 2015, p. 8). Because markets are
imperfect and factors of production are somewhat immobile, comparative cost advantages
can remain between international markets (Madura 2015, p. 8). This provides an incentive
for firms to seek out foreign opportunities and capitalise on a countrys particular
resources (Madura 2015, p. 8). MNCs such as Nike often capitalise on a foreign countrys
particular resources (Madura 2015, p. 8).

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Activity 1.3

Complete question 4 (part a) on page 23 of the textbook (Madura 2015): Do you think that
the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which
alternative is likely to have more risk?

Madura (2015, p. 11) explains that:

Firms frequently acquire other firms in foreign countries as a means of penetrating
foreign markets. Such acquisitions give firms full control over their foreign businesses
and enable the MNC to quickly obtain a large portion of foreign market share.
However, the acquisition [can] lead to large losses because of the large investment
required. In addition, if the foreign operations perform poorly, it may be difficult to sell
the operations at a reasonable price.

An acquisition will typically result in greater growth, but is more risky because it normally
requires a larger investment and the decision cannot be easily reversed once the acquisition
is made.

Activity 1.4

Complete question 5 (part b) on page 23 of the textbook (Madura 2015): Offer your opinion
on why the Internet may result in more international business.

The Internet allows for easy and low-cost communication between countries, so that firms
can now develop contacts with potential customers overseas by having a website. Many
firms use their websites to list the products that they sell along with the price for each
product (Madura 2015, p. 10). This allows them to easily advertise their products to
potential importers anywhere in the world, without mailing brochures to various countries
(Madura 2015, p. 10). In addition, they can add to their product line or change prices by
simply revising [their] website, so importers need only check an exporters website
periodically in order to keep abreast of its product information (Madura 2015, p. 10). Firms
can also use their websites to accept orders online (Madura 2015, p. 10). Some firms with
an international reputation use their brand name to advertise products over the Internet.
They may use manufacturers in some foreign countries to produce some of their products
subject to their specification.

Activity 1.5

Complete question 3 on page 58 of the textbook (Madura 2015:, How can government
restrictions affect international payments among countries?

Governments can have a major impact on the international flows of goods and finance and
hence international payments among countries. For example, they can place tariffs or
quotas to restrict imports. They can also impose restrictions based on environmental
legislation, labour laws, security legislation or business Laws, for example. Governments may

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also decide to place taxes on income from foreign securities, thereby discouraging investors
from purchasing foreign securities. Governments may also impose restrictions on direct
foreign investment, such as restrictions on the purchase of strategic business assets or real-
estate, for example.

Activity 1.6

Complete question 2 (part a) on page 58 of the textbook (Madura 2015): How would a
relatively high home inflation rate affect the home countrys current account, other things
being equal?

If a countrys inflation rate increases relative to the countries with which it trades, then
consumers and corporations in that country will most likely purchase more goods overseas
due to higher prices in the home country (Madura 2015, p. 42). However, inflation may have
a limited effect on the balance of trade in the case where wages are much higher in the
home country compared with main trading partners (Madura 2015, p. 43). As the wage
component remains a high proportion of the cost of production for many goods, a
developing country experiencing increasing inflation rates may still have a price advantage
compared to the home country, due to the relatively low cost of labour.

Activity 1.7

Complete question 12 (part a) on page 59 of the textbook (Madura 2015): Assume that the
dollar is presently weak and is expected to strengthen over time. How will these expectations
affect the tendency of U.S. investors to invest in foreign securities?

The expectations of a strong dollar in the future would discourage U.S. investors from
investing abroad. If the dollar is relatively weak now, U.S. investors need more dollars to
purchase foreign currency (when investing). If the dollar strengthens over the time of their
investment horizon, they will exchange the foreign currency (as the investment is liquidated)
into dollars at a less favourable exchange rate than the exchange rate at which they initially
converted dollars into the foreign currency. That is, the exchange rate effect would reduce
the yield that they earn on their investment.

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Activity 1.8

Complete question 4 on page 58 of the textbook (Madura 2015):

a. What are the major objectives of the IMF?

b. How is the IMF involved in international trade?

The main objectives of the IMF according to Madura (2015, p. 54):

are to (1) promote cooperation among countries on international monetary issues,
(2) promote stability in exchange rates, (3) provide temporary funds to member
countries attempting to correct imbalances in international payments, (4) promote
free mobility of capital funds across countries, and (5) promote free trade.

The IMF is involved in international trade because it attempts to stabilise international

payments, and trade represents a significant portion of international payments between
countries. Thus, a country experiencing financial problems resulting from reduced export
earnings can receive the assistance of the IMF through its compensatory financing facility
(CFF).

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