The primary objective of this book is to help the reader understand basic principles of global
finance. Before we advance too far into the material, perhaps it would be helpful to take a brief
look at some of these principles so that you may see where we are heading.
As discussed earlier, the financial manager has three major functions: financial planning and
control, the acquisition of funds, and the allocation of funds. However, each of these three functions
shares most principles of global finance and their relationships. Seven important principles
of global finance are introduced in this section. In addition, these principles should help you
understand why MNCs perform better than domestic companies.
The risk–return trade-off
The maximization of stockholder wealth depends on the trade-off between risk and profitability.
Generally, the higher the risk of a project, the higher is the expected return from the project.
For example, if you are offered a chance to invest in a project that offers an extremely high rate
of return, you should immediately suspect that the project is very risky.
The risk–return trade-off does not apply to 100 percent of all cases, but in a free enterprise
system, it probably comes close. Thus, the financial manager must attempt to determine the
optimal balance between risk and profitability that will maximize the wealth of the MNC’s stockholders.
Figure 1.1 shows how the financial manager assesses the various risk–return trade-offs
available and incorporates them into the wealth maximization goal. Given the risk–return tradeoffs,
various financial decisions are made to maximize stockholder wealth. Practically all financial
decisions involve such trade-offs. Such decisions include foreign-exchange risk management,
global reporting and controlling, global financing decision, and global investment decision.
An investor’s risk–return trade-off function is based on the standard economic concepts of
utility theory and opportunity sets. An opportunity set shows different combinations of business
opportunities, which make the investor equally happy in terms of risk–return trade-offs.
Companies can benefit from an expanded opportunity set as they venture into global markets.
It seems reasonable to assume that international business is riskier than domestic business. However,
this is not necessarily true, because returns on foreign investments are not highly positively correlated
with returns on domestic investments. In other words, MNCs may be less risky than companies
that operate strictly within the boundaries of any one country. Consequently, to minimize risk,
companies should diversify not only across domestic projects but also across countries.
Possible revenue opportunities from international business are also larger than possible revenue
opportunities from purely domestic business. MNCs can locate production in any country of
the world to maximize their profits and raise funds in any capital market where the cost of capital
is the lowest. MNCs may see another advantage from currency gains. These two factors – lower
risks and larger profitability for international business – suggest the possibility that an MNC can
achieve a better risk–return trade-off than a domestic company.
Figure 1.2 shows that international business pushes out the opportunity set, thus allowing
MNCs to reduce risk, increase return, or attain both. As shown in figure 1.2, we can think of
three possible cases in which international operations are better than domestic operations. Relative
to US project A, international project B has the same return but less risk; international project
C has the same risk but higher return; and international project D has higher return but less risk.
You have perhaps heard on the news that the Japanese and the Americans are competitors in the
global economy. In some ways, this is true, because American and Japanese companies produce
many of the same goods. Ford and Toyota compete for the same customers in the market for
automobiles. However, trade between the USA and Japan is not like a sports contest, where one
team wins and the other team loses. In fact, the opposite is true. Trade between two countries
can make each country better off.
The classical argument for free trade is based on the principle of comparative advantage.
Assume that US workers are better at producing computer software than workers in China and
that Chinese workers are better at producing shoes than workers in the USA. Comparative advantage
states that trade between the two countries – the USA exporting software and China exporting
shoes – can boost living standards in both. This is because the USA has comparative advantage
in producing software while China has comparative advantage in producing shoes. Trade allows
countries to specialize in what they do best and to enjoy a greater variety of goods and services.
At the same time, companies earn profits from trade because most trade is carried out by individual
companies.
finance. Before we advance too far into the material, perhaps it would be helpful to take a brief
look at some of these principles so that you may see where we are heading.
As discussed earlier, the financial manager has three major functions: financial planning and
control, the acquisition of funds, and the allocation of funds. However, each of these three functions
shares most principles of global finance and their relationships. Seven important principles
of global finance are introduced in this section. In addition, these principles should help you
understand why MNCs perform better than domestic companies.
The risk–return trade-off
The maximization of stockholder wealth depends on the trade-off between risk and profitability.
Generally, the higher the risk of a project, the higher is the expected return from the project.
For example, if you are offered a chance to invest in a project that offers an extremely high rate
of return, you should immediately suspect that the project is very risky.
The risk–return trade-off does not apply to 100 percent of all cases, but in a free enterprise
system, it probably comes close. Thus, the financial manager must attempt to determine the
optimal balance between risk and profitability that will maximize the wealth of the MNC’s stockholders.
Figure 1.1 shows how the financial manager assesses the various risk–return trade-offs
available and incorporates them into the wealth maximization goal. Given the risk–return tradeoffs,
various financial decisions are made to maximize stockholder wealth. Practically all financial
decisions involve such trade-offs. Such decisions include foreign-exchange risk management,
global reporting and controlling, global financing decision, and global investment decision.
An investor’s risk–return trade-off function is based on the standard economic concepts of
utility theory and opportunity sets. An opportunity set shows different combinations of business
opportunities, which make the investor equally happy in terms of risk–return trade-offs.
Companies can benefit from an expanded opportunity set as they venture into global markets.
It seems reasonable to assume that international business is riskier than domestic business. However,
this is not necessarily true, because returns on foreign investments are not highly positively correlated
with returns on domestic investments. In other words, MNCs may be less risky than companies
that operate strictly within the boundaries of any one country. Consequently, to minimize risk,
companies should diversify not only across domestic projects but also across countries.
Possible revenue opportunities from international business are also larger than possible revenue
opportunities from purely domestic business. MNCs can locate production in any country of
the world to maximize their profits and raise funds in any capital market where the cost of capital
is the lowest. MNCs may see another advantage from currency gains. These two factors – lower
risks and larger profitability for international business – suggest the possibility that an MNC can
achieve a better risk–return trade-off than a domestic company.
Figure 1.2 shows that international business pushes out the opportunity set, thus allowing
MNCs to reduce risk, increase return, or attain both. As shown in figure 1.2, we can think of
three possible cases in which international operations are better than domestic operations. Relative
to US project A, international project B has the same return but less risk; international project
C has the same risk but higher return; and international project D has higher return but less risk.
You have perhaps heard on the news that the Japanese and the Americans are competitors in the
global economy. In some ways, this is true, because American and Japanese companies produce
many of the same goods. Ford and Toyota compete for the same customers in the market for
automobiles. However, trade between the USA and Japan is not like a sports contest, where one
team wins and the other team loses. In fact, the opposite is true. Trade between two countries
can make each country better off.
The classical argument for free trade is based on the principle of comparative advantage.
Assume that US workers are better at producing computer software than workers in China and
that Chinese workers are better at producing shoes than workers in the USA. Comparative advantage
states that trade between the two countries – the USA exporting software and China exporting
shoes – can boost living standards in both. This is because the USA has comparative advantage
in producing software while China has comparative advantage in producing shoes. Trade allows
countries to specialize in what they do best and to enjoy a greater variety of goods and services.
At the same time, companies earn profits from trade because most trade is carried out by individual
companies.
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