INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

CHAPTER 16

CORPORATE STRATEGY AND FOREIGN INVESTMENT ANALYSIS

Most corporate finance texts imply that the most important part of the investment decision is to calculate and
discount project cash flows, selecting only those projects with positive net present values--projects that have returns
in excess of those required by shareholders. But this view begs the question of how positive NPV projects arise in
the first place. Finding positive NPV projects is equivalent to picking undervalued assets: a futile task if markets are
efficient. That brings up the following key points.

KEY POINTS
1. The essence of corporate strategy is to create the conditions under which positive NPV projects will exist.
Specifically, this involves creating and exploiting imperfections in product and factor markets. The continued
existence of market imperfections depends on the maintenance of barriers to entry: patented technology, economies
of scale, high advertising expenditures, unique sources of raw materials, and the like.

2. The continued existence of multinational firms depends on their ability to transfer overseas their sources of
domestic advantage. This chapter emphasizes the various means whereby MNCs create, preserve, and transfer
abroad their competitive strengths. The most important spawner of MNCs is market failures in the areas of
firm-specific information and skills. There are various transactions, contracting, and coordinating costs involved in
trying to sell a firm's managerial skills and knowledge apart from the goods it produces. To overcome these costs,
many firms have created an internal market, one in which these firm-specific advantages can be embodied in the
services and products they sell.

I present a simplified approach to developing a global expansion strategy that involves three interrelated aspects:
establishing objectives; developing policies to achieve these objectives; and ensuring that the firm's resources are
sufficient to carry out these policies. My emphasis throughout this chapter is not so much on the international
aspects of strategy as on the basic underlying principle of corporate strategy, namely to develop and capitalize on
product and factor market imperfections.

SUGGESTED ANSWERS TO “THE U.S. TIRE INDUSTRY GETS RUN OVER”

1. What barriers to entry has Goodyear created or taken advantage of?

ANSWER. Goodyear has erected several barriers to entry. Its size enables it to gain important economies of scale,
thereby driving down its costs relative to those of its competitors. Production cost cutting is facilitated by investment
in advanced process technology. Automated plant facilities also enable it to respond more rapidly to changing
market conditions. By owning its own stores, Goodyear has secured proprietary access to an important channel of
distribution. Finally, through its investment in R&D and niche marketing (high-performance tires), Goodyear has
created product differentiation and a high quality image. New competitors would incur substantial costs to duplicate
that reputation.

2. Goodyear has production facilities throughout the world. What competitive advantages might global production
provide Goodyear?

ANSWER. Since tires are bulky and expensive to ship relative to their profit margins, Goodyear has found it
advantageous to locate production facilities near the ultimate points of sale. This reduces distribution costs and
provides significant barriers to entry. It also reduces Goodyear's foreign exchange risk.

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3. How do tire-manufacturing facilities in Japan fit in with Goodyear's strategy to create shareholder value?

ANSWER. The tire industry is globalizing. Goodyear recognizes that one of its principal competitors in the future
will be Bridgestone Tire of Japan. Setting up production facilities in Japan would enable Goodyear to punish
Bridgestone by cutting price in its critical home market if Bridgestone tries to gain market share in the U.S. through
aggressive price cutting. At the same time, Japanese car manufacturers will be able to produce two million vehicles
a year in the United States by 1992. Sales of these vehicles will cut into car sales by domestic auto companies,
reducing demand for Goodyear tires by Ford, G.M., and Chrysler. Goodyear would like to replace some of that lost
business with sales to Japanese manufacturers producing in the U.S. Setting up a plant in Japan will enable
Goodyear to develop a better supplier relationship with Japanese auto companies, and facilitate sales to their U.S.
plants. Goodyear is well-positioned to supply these Japanese firms since they are upgrading their cars and need
high-quality tires, such as those supplied by Goodyear.

4. How will Bridgestone's acquisition of Firestone affect Goodyear? How might Goodyear respond to this move
by Bridgestone?

ANSWER. The acquisition will most likely affect Goodyear adversely since it introduces a well- financed competitor
seeking to garner some of the monopoly rents currently being earned by Goodyear. However, given the
life-and-death struggle American car manufacturers are currently engaged in with Japanese companies, they may
decide to take some of the business they are currently giving to Firestone and reallocate it to Goodyear. Goodyear
might counterattack with price cuts, product and process innovation, or guarantees. To be most effective, Goodyear
should direct its price cutting response to the Japanese market.

SUGGESTED ANSWERS TO CHAPTER 16 QUESTIONS

1. Why do firms from each category below become multinational? Identify the competitive advantages that a firm
in each category must have to be a successful multinational.

a. Raw-materials seekers

b. Market seekers

c. Cost minimizers

ANSWER. FDI is most likely to be economically viable where the possibility of opportunism on the part of unrelated
parties or contractual difficulties make it especially costly to coordinate economic activities via arm's length
transactions in the marketplace. They go overseas to more fully utilize their skills and other tangible and intangible
assets.

Raw materials seekers. The existence of low-cost raw materials overseas is not a sufficient condition for these firms
to become multinational; they could just import raw materials rather than set up operations abroad to extract them.
Companies that become raw materials MNCs must:

a) have intangible capabilities in the form of technical skills and face contractual difficulties in the form of an
inability to price their know-how or to write, monitor, and enforce use restrictions governing technology transfer
arrangements.

b) face problems of opportunism that make it very expensive to enter into long-term purchase contracts to fully
utilize their production or distribution capability. For example, an oil refining and distributing firm may find it too
risky to invest in further refining capacity without controlling its own oil supply. An independent supplier may
decide to break a contractual agreement and cut off the flow of oil to the refiner.

Market seekers. These firms usually have intangible capital in the form of organizational skills that are inseparable
from the firm itself. A basic skill involves knowledge about how best to service a market, including new product
 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

development and adaptation, quality control, advertising, distribution, and after-sales service. Since it would be
difficult, if not impossible, to unbundle these services and sell them apart from the firm, this form of market
imperfection often leads to corporate attempts to exert control directly via the establishment of foreign affiliates.

Cost minimizers. These firms seek to reduce their costs by producing overseas. Yet the existence of lower-cost
production sites overseas is not sufficient to justify FDI. Since local firms have an inherent cost advantage over
foreign investors, multinationals can succeed abroad only if the production or marketing edge they possess cannot be
purchased or duplicated by local competitors. The successful MNC in this category will possess specialized design
or marketing skill, a good distribution system, or own a strong brand name. Excess profits are earned on these
intangible assets, not on the low foreign labor or materials costs. Overseas production just enables them to be cost
competitive; it doesn't give them an edge since any competitor can replicate its production location.

2.a. Why do companies generally follow a sequential strategy in moving overseas?

ANSWER. The usual sequence of overseas expansion involves exporting, setting up a foreign sales subsidiary,
possible licensing agreements and, eventually, foreign production. This sequential approach can be viewed as a
risk-minimizing response to operating in a highly uncertain foreign environment. By internationalizing in phases, a
firm can gradually move from a relatively low risk-low return, export-oriented strategy to a higher risk-higher return
strategy emphasizing international production. In effect, the firm is investing in information, learning enough at each
stage to significantly improve its chances for success at the next stage.

b. What are the pluses and minuses of exporting? Licensing? Of foreign production?

ANSWER. Exporting is a low-cost, low-risk strategy for learning about and developing foreign markets. At the same
time, it limits a company's ability to fully exploit foreign markets. By producing abroad, a company can more easily
keep abreast of market developments, adapt its products to local tastes and conditions, and provide more
comprehensive after-sales service. And while foreign production often requires a substantial capital investment, it
may allow a company to access lower cost local labor and materials. It also demonstrates a tangible commitment to
the local market and an increased assurance of supply stability. Instead of spending the money to set up production
facilities abroad, the company can license a local firm to manufacture its products. Licensing also allows the
company to access its licensee's marketing smarts and distribution network. But licensing may create a competitor in
other markets because it is often difficult to control exports by foreign licensees. It may also be difficult to displace
the licensee in the local market once the license expires.

3. What factors help determine whether a firm will export its output, license foreign companies to manufacture its
products, or set up its own production or service facilities abroad? Identify the competitive advantages that lead
companies to prefer one mode of international expansion over another.

ANSWER. Here are some factors involved in deciding how to enter a market:

i) Production economies of scale. If these are important, then exporting might be the appropriate answer.

ii) Trade barriers. Companies that might otherwise be inclined to export to a market may be forced by regulations
to produce abroad, either in a wholly-owned operation, a joint venture, or through a licensing arrangement with a
local manufacturer.

iii) Transportation costs. These have the same effect as trade barriers. The more expensive it is to ship a product
to a market, the more likely it is that local production will take place.

iv) Size of the foreign market. The larger the local market, the more likely local production is to take place,
particularly if there are significant production economies of scale. Conversely, with smaller markets, exporting is
more likely to take place.

v) Production costs. The real exchange rate, wage rates, and other cost factors will also play a part in determining
whether exporting or local production takes place.

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vi) Intangible capital. If the multinational's intangible capital is embodied in the form of products, then exporting
will generally be preferred. If this intangible capital takes the form of specific product or process technologies that
can be written down and transmitted objectively, then foreign expansion will usually take the licensing route. But if
this intangible capital takes the form of organizational skills that are inseparable from the firm itself, then the firm is
likely to expand overseas via direct investment.

vii) Necessity of a foreign market presence. By investing in fixed assets abroad, companies can demonstrate to
local customers their commitment to the market. This can enhance sales prospects.

4. Time Warner is trying to decide whether to license foreign companies to produce its films and records or to set
up foreign sales affiliates to sell its products directly. What factors might determine whether it expands abroad
via licensing or by investing in its own sales force and distribution network?

ANSWER. Some of the factors that Warner should consider in determining whether it expands abroad via licensing
or by investing in its own sales force and distribution network are as follows:

a) Sales volume. It needs a certain minimum volume of business to justify its own sales force.

b) Potential problems of opportunism. How easy is it to monitor and control independent producers and sellers
of its films and records? The easier it is to monitor and control them, the less value there is in having its own sales
and distribution capability.

c) Conflicts of interest. How motivated will independents be in pushing Warner's products versus those of other
companies?

d) Collateral benefits to Warner. To the extent that Warner gets other benefits from distributing its movies (e.g.,
the sale of toys) that aren't captured by independents, they will have less incentive to push Warner's products than
Warner will have. The more the collateral benefits, the more important it is for Warner to control its own sales.

e) The importance of market information. If products must be tailored to the foreign markets, then Warner
should probably develop its own sales force. Warner will find it difficult to gather the necessary market intelligence
from independent distributors of its products.

5. Given the added political and economic risks that appear to exist overseas, are multinational firms more or less
risky than purely domestic firms in the same industry? Consider whether a firm that decides not to operate
abroad is insulated from the effects of economic events that occur outside the home country.

ANSWER. Individual foreign projects may face more political and economic risks than comparable domestic
projects. Yet, multinationals are likely to be less risky than purely domestic firms. The reason is that much of the
risk faced overseas is diversifiable risk. Moreover, by operating and producing overseas, the multinational firm has
diversified its cost and revenue structure relative to what it would be if it were a purely domestic firm producing and
selling in the home market. It is important to note that domestic firms are not insulated from economic changes
abroad. For example, domestic firms face exchange risk since their competitive position depends on the cost
structure of their foreign competitors as well as their domestic competitors. Similarly, changes in the price of oil and
other materials abroad immediately lead to changes in domestic prices.

6. How is the nature of IBM's competitive advantages related to its becoming a multinational firm?

ANSWER. IBM is selling more than black boxes; it is selling a stream of services associated with its computers. In
effect, customers are buying the company. In order for IBM to provide customers with what they think they are
buying, it must be there on the spot. This enables IBM to service customers' machines as well as tailor software and
systems to their specifications.

7. Black & Decker, the maker of small, hand-held power tools, finds that when it builds a plant in a foreign
country, sales of both its locally manufactured products and its exports to that country grow. What could
 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

account for this boost in sales? Consider the likely reactions of customers, distributors, and retailers to the fact
that Black & Decker is producing there.

ANSWER. Local production demonstrates a commitment to the marketplace that is important to customers,
distributors, and retailers. Each of these stakeholders is looking for evidence that the firm will not pack up and move
on if the market doesn’t pan out. If B&D departs the market, customers will be stuck with unserviceable products,
distributors will lose the time and money they invested in pushing the product, and retailers will be stuck with
unsalable inventory. By putting its money where its mouth is--by investing and producing locally--Black & Decker
demonstrates in a tangible way--since it will probably have to sell its local facilities at a loss if it exits the market--
that it is committed to the local market. This encourages distributors to invest in training sales and service people. At
the same time, customers are more willing to buy B & D's products since they are less concerned about getting their
products serviced in the future. These factors, in turn, encourage retailers to stock its products.

8. What was the Japanese strategy for penetrating the TV market? What similarities are there between it and the
Japanese strategy for entering the U.S. car market? The photocopier market?

ANSWER. Without strong brand names or distribution capabilities, but with a labor cost advantage, Japanese
television manufacturers entered the U.S. market by selling low-cost private-label black and white TVs. By the late
1960s they had built a large volume base selling private-label TVs. Using this volume base, they invested in new
process and product technologies, from which came the advantages of scale and quality. Recognizing the transient
nature of a competitive advantage built on labor and scale advantages, Japanese companies, like Matsushita and
Sony, strengthened their competitive position in the U.S. market by investing throughout the 1970s to build strong
brand franchises and distribution capabilities. The new product positioning was facilitated by large-scale
investments in R&D. By the 1980s, the Japanese competitive advantage in TVs and other consumer electronics had
switched from being cost-based to one based on quality, features, and strong brand names and distribution systems.

The similarities to the Japanese strategy for entering the car and copier markets are very strong. In each case, the
Japanese have started at the low end of the market, a market segment that had been largely ignored by American
firms focusing on higher margin products. At the same time, they invested money in process technologies and
simpler product design to cut costs and expand market share. Japan's lower cost products sold in high volume,
giving the manufacturers production economies of scale that other contenders could not match. American companies
retreated to the high-end segment of each market. But the Japanese weren't content to remain in the low-end
segment of the market. Over time, they invested in new product development, built strong brand franchises and
global distribution networks, and moved up market.

9. The value of a particular foreign subsidiary to its parent company may bear little relationship to the subsidiary's
profit-and- loss statement. The strategic purpose or nature of a foreign unit may dictate that some of the value of
the unit will show up in the form of higher profits in other affiliates.

a. Describe three ways in which the incremental cash flows associated with a foreign unit can diverge from its
actual cash flows.

ANSWER. Here are several ways in which the incremental cash flows associated with a foreign affiliate can diverge
from its actual cash flows.

-- Transfer prices on goods, services, and capital transferred internally do not accurately reflect opportunity costs
-- Fees, royalties and overhead allocations are benefits to the parent even though they are costs to the affiliates
-- The affiliate creates incremental sales by other units
-- The affiliate cannibalizes sales of other units, e.g., lost export sales
-- Additional taxes are owed when repatriating profits
-- Foreign tax credits are usable elsewhere
-- Currency controls restrict repatriation of affiliate cash flow

b. Describe two strategic rationales for establishing and maintaining a foreign subsidiary that will lead to higher
profits elsewhere in the corporation, but will not be reflected in the subsidiary's profit-and-loss statement.

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ANSWER. Multinationals have many strategic motivations for going abroad which are not necessarily expressed in
ROI calculations. For example, a firm may willingly forgo economies of scale in production in order to achieve
greater security of supply by having multiple and redundant production facilities. In addition, operating in several
nations may give a firm greater bargaining leverage in dealing with local governments or labor unions. Being
multinational may also lower the firm's risk profile by reducing its dependence on the state of just one nation's
economy. Going overseas may also enable a company to hold onto domestic customers who are MNCs that it might
otherwise lose. In addition, the unit might provide a key link in a global service network that enables the firm to
charge higher prices or gain customers that it would otherwise not have. Locating an affiliate in a foreign
competitor's home market may also deter the competitor from launching a market share battle by posing a credible
retaliatory threat to the competitor's profit base.

10. In 1989, the British company Beecham Group merged with the U.S. company SmithKline Beckman in a deal
valued at $8.3 billion. What economic advantages might the two drug companies be expecting from their
marriage? How does this merger reflect the process of globalization in the world pharmaceutical industry?
Consider the merger's impact in the areas of R&D, marketing, and production.

ANSWER. Beecham and SmithKline Beckman expect to take greater advantage of economies of scale in R&D and
production, and economies of scope in marketing. The latter stems from the fact that a key cost of marketing drugs
is maintaining a large sales force. Adding new drugs to the drugs currently being sold by a sales force does not add
much to the total cost of maintaining that sales force in the field. An advantage of merging a British and a U.S. firm
is that the companies will gain greater ability to sell their drugs in each other's markets. Greater sales volume will
raise the return on investments in R&D and marketing and thereby enable the company to invest more, particularly
in R&D. R&D is a fixed cost and by spreading that cost over more units, the average R&D cost per unit sold is
lower and the return on selling that product is higher. Having the products and the ability to sell overseas is critical
in an industry undergoing globalization. The quicker a company can take its products to market, and the more
markets it can sell its products in, the more competitive the company will be relative to companies that are limited to
selling in their home markets.

ADDITIONAL CHAPTER 16 QUESTIONS AND ANSWERS

1. What are the important advantages of going multinational? Consider the nature of global competition.

ANSWER. Some important advantages of going multinational are

a) Taking fuller advantage of economies of scale in production and research and development

b) Taking fuller advantage of economies of scope in marketing and R&D

c) Taking advantage of lower cost sources of production

d) Posing a credible retaliatory threat against foreign competitors

e) Gaining information and experience that is expected to prove useful elsewhere.

f) Keeping domestic customers who become multinational by following them abroad and guaranteeing them a
continuing product flow

g) Diversifying revenues and costs so as to reduce operating risk

2. OPEC nations have obviously preferred portfolio investments abroad to direct foreign investment. How does
the theory of market imperfections explain this preference?

ANSWER. According to Stephen Kobrin and Donald Lessard, "Large-Scale OPEC Investment in U.S. Enterprise and
the Theory of Foreign Direct Investment: A Contradiction," Weltwirtschaftliches Archiv, December 1976, pp.
 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

660-673, their lack of monopolistically-held organizational advantages has led OPEC nations to prefer foreign
portfolio investments to foreign direct investment. Control of foreign firms will benefit OPEC nations only if they
have transferable skills that enable them to earn higher returns than current managers can. Since they are widely
perceived as lacking these skills, the lower transactions costs associated with purchasing securities abroad as
compared to buying control of foreign firms have probably proven decisive in OPEC investment decisions.

3. What are the benefits of having a global distribution capability?

ANSWER. A global distribution capability helps build market share. This, in turn, aids companies whose strategy is
geared to taking full advantage of scale economies; investment in large-scale manufacturing facilities may only be
justified if the firm has made supporting investments in foreign distribution and brand awareness. Global
distribution may also deter a foreign competitor from launching a market share battle by posing a credible retaliatory
threat to the competitor's profit base. In addition, a global distribution capability may be critical in exploiting new
technology by enabling the firm to quickly push products embodying that technology through distribution networks
in each of the world's critical national markets.

4. How sustainable is a competitive advantage based on technology? On low-cost labor? On economies of scale?
Explain.

ANSWER. Competitive advantages based on technology, low cost labor, or economies of scale are unlikely to persist
for long. The imitation lag in technology keeps shortening, so a company has to continually be first to market with
new products to maintain a competitive advantage based on technology. This is highly unlikely. With regard to low
cost labor, it is not a sustainable competitive advantage since all companies have access to the same labor pool. And
as markets grow and become globalized, more firms can achieve the large scale of operations necessary to take full
advantage of economies of scale.

5. What could account for the fact that most European and Japanese automakers have design studios in the United
States, and especially California?

ANSWER. Automakers around the world predict that the real advances in car design will come from the United
States because of its competitive free-for-all. According to the head of Nissan's California design studio (Wall Street
Journal, March 2, 1995, p. B1), "This is the design fast track. That's why the European and Japanese companies
have design studios in America. This is where everybody comes to test their mettle." Why California? Because no
state is as car conscious or has customers who are as demanding and ahead of the curve as California. What sells in
California will eventually sell elsewhere.

6. Politicians, business executives, and the media lament the sale of corporate America to foreign buyers. Recent
foreign acquisitions include Firestone Tire, Pillsbury, and CBS Records. A persistent theme sounded by
executives and the business press is that the depreciated dollar offers a significant financial advantage to foreign
bidders for American companies. According to this argument, if the dollar has depreciated relative to, say, the
yen, a Japanese company can buy a U.S. company at a discount. Evaluate this argument.

ANSWER. This argument is based on fallacious reasoning. Suppose the dollar declines relative to the yen. This
means that for a given dollar bid, a Japanese company will have to spend less yen to acquire a U.S. company.
However, while the devalued dollar enables the Japanese company to buy the U.S. company at a discount, post-
acquisition dollar cash flows are correspondingly less valuable when converted back into yen at the current
exchange rate. To illustrate, assume the Japanese firm bid $100 million for an American company when the
exchange rate was ¥260 = $1. From the buyer's perspective, the bid was ¥26 billion. The estimated value of the
seller's cash flows was $120 million or equivalently ¥31.2 billion. The Japanese buyer then expects to create ¥5.2
billion of value or a 20% return on its ¥26 billion investment.

Now suppose that the yen appreciates by 100% relative to the dollar to a new level of ¥130 = $1. The $100 million
bid now costs the Japanese firm only ¥13 billion. But the American firm's cash flows of $120 million when
converted to yen at the current exchange rate are worth only ¥15.6 billion. Despite the dollar's depreciation, the
Japanese company still expects to earn a 20% return on its investment. To be specific, it expects to create ¥2.6
billion of value on its investment of ¥13 billion. The depreciation of the dollar reduces the acquisition price and the

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value of the post-acquisition dollar cash flows by the identical percentage; therefore, the acquirer's rate of return
remains the same. In summary, a cheaper acquisition does not necessarily create more value.

Foreign companies may pay more for U.S. companies because they view U.S. acquisitions from a global
perspective. For example, Japan's Bridgestone paid a $2 billion premium for Firestone based, in part, on its desire to
keep its Japanese car manufacturers as customers as they shift some of their operations to North America. Similarly,
Grand Metropolitan (a British company) paid a big premium to acquire Pillsbury in order to develop its Pillsbury,
Burger King and Haagen-Dazs brand names into international household names such as McDonald's and Kentucky
Fried Chicken.

7. The chapter mentions that Hyundai shifted its PC business to the United States.

a. What advantages might Hyundai realize from servicing the U.S. market locally as opposed to operating out of
South Korea?

ANSWER. With their low labor costs and growing mass-production skills, Hyundai and other Asian producers
stamped out low-priced clones for sale in the U.S. market. But that strategy has ended its useful life because the U.S.
market has been changing so fast that new products go out of date quickly, calling for on-the-spot decisions. With
R&D, design, factories, and warehouses an ocean away from the U.S. market, Asian companies found it
increasingly hard to meet the changing demands of U.S. consumers. In addition, individual PC buyers have grown
more and more finicky, wanting their machines built with specific choices of microprocessors, disk drives, and other
components. Asian factories, set up for high-volume production of a few types of machines, found it increasingly
difficult to keep up with these changing configuration demands. They were at a further disadvantage because they
must spend weeks or months shipping products to market. Recognizing that handicap, Hyundai concluded that it
could best compete by Americanizing its business as much as possible.

b. What competitive advantages are Hyundai likely to bring to the U.S. market?

ANSWER. The likely answer is none. Historically, Hyundai's competitive advantage has been low-cost South Korean
labor. But given that Hyundai is now cut off from its low-cost production base in South Korea and is a multi-faceted
conglomerate, it is doubtful that it will be able to compete effectively against U.S. firms that are devoted solely to
PC research, production, marketing, and distribution.

8. Hershey Foods, maker of the Hershey bar, and Gerber Products, of baby-food fame, have dominant positions in
the United States and strong brand names but little presence overseas.

a. What appeals might expanding their foreign operations hold for them?

ANSWER. Many people outside the United States have become familiar with their brands, so selling overseas would
enable Hershey Foods and Gerber Products to expand foreign sales at a lower cost than if they had to start from
scratch. Other things being equal, this increases the profitability of foreign operations. At the same time, both
companies are facing increased competition in their home market from both domestic and foreign companies selling
both branded and private-label products. By selling abroad, Hershey and Gerber can also afford to invest more
money in brand awareness, new product development, and new process technologies (boosting their
competitiveness) since they can now amortize these costs, which are largely fixed, over higher unit sales. Operating
overseas will also expose the firms to new products and new process technologies that they can bring back to the
U.S. and will provide them with market intelligence as to what their foreign competitors (such as Nestlé in the case
of Hershey) are likely to try next in the U.S. Selling abroad will also give them the ability to retaliate against foreign
companies like Nestlé (Swiss) and Unilever (Anglo-Dutch) that now have extensive U.S. operations. Perhaps the
most important reason for selling abroad, though, is that foreign sales can offset sluggish U.S. food sales growth
owing to saturated markets and slowing population growth.

b. Would foreign operations increase their risks by exposing them to political and economic risks seldom, if ever,
encountered in the U.S. market?
 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

ANSWER. As the text points out, most of the risks that firms face abroad are also faced domestically. For example,
both companies face currency risk in the U.S. to the extent that they face competitors who are producing abroad and
selling in the U.S. market. If the dollar appreciates, these competitors become more cost-competitive. Any company
operating in the U.S. faces political risk as well, such as changes in tax and regulatory laws, but they may face some
political risks overseas that they don't face domestically, such as currency controls and expropriation. Nonetheless,
the empirical evidence suggests that the net effect of operating internationally is to lower risk because of the
diversification effect of operating across countries with different business cycles.

c. What options do these companies have for going overseas?

ANSWER. For companies starting as late as they are, the most typical route to international expansion is to acquire
foreign companies (in fact, Gerber was acquired by Sandoz, a Swiss company, in 1994). They can also export, set up
manufacturing operations in the local markets (ranging from packaging imported materials to full-scale production),
license local companies to use their name and/or product technologies, and form joint ventures. Some recent food
joint ventures include ones set up by BSN (French) and Unilever, Nestlé and General Mills, and Nestlé and Coca-
Cola.

9. Shortly after British Telecommunications announced plans to offer international communications lines to
multinational companies in the United States, AT&T sought approval from the British government to sell global
services to corporations with offices in Britain. Similarly, following the announcement of plans of the Stentor
long-distance consortium in Canada to join forces with MCI Communications in the United States, AT&T
agreed to buy a stake in Canada's MCI-like start-up Unitel Communications.

a. What is AT&T's likely motivation for these moves?

ANSWER. Many multinationals are seeking the same kind of uniform, seamless communications service worldwide
that they enjoy in their domestic markets along with one-stop shopping for these global services. By establishing
operations in foreign countries or linking up with foreign telecommunications companies, AT&T is able to provide
such global services to its clients. At the same time, AT&T is clearly concerned that if it can't provide such service,
it may lose some of its customers to competitors who can. Most importantly, these moves by AT&T send a loud
signal to foreign competitors seeking to take market share in the United States that it has, or will develop, the
capacity to retaliate in their home market against them. For example, if BT cuts price in the U.S. to gain market
share, AT&T can retaliate with price cuts in Britain. Similarly, through its linkup with Unitel, AT&T can respond in
Canada to moves by Stentor in the U.S. market. Knowing AT&T's capabilities, BT and Stentor are less likely to use
price cuts in the U.S. market to gain market share.

b. Suppose an analysis indicated that the net present values of AT&T's moves into Britain and Canada were
negative. Would this result indicate that AT&T made the wrong decision? Explain.

ANSWER. No. The gains to AT&T can come through reduced competitive pressure in the U.S. market, thereby
protecting its U.S. base and boosting its U.S. profits. These gains would not show up in an analysis focused solely
on the returns to its investments in Britain and Canada, but they would be real nonetheless.

SUGGESTED SOLUTIONS TO CHAPTER 16 PROBLEMS

1. Suppose the worldwide profit breakdown for General Motors is 85 percent in the United States, 3 percent in
Japan, and 12 percent in the rest of the world. Its principal Japanese competitors earn 40 percent of their profits
in Japan, 25 percent in the United States, and 35 percent in the rest of the world. Suppose further that through
diligent attention to productivity and substitution of enormous quantities of capital for labor (for example,
Project Saturn), GM manages to get its automobile production costs down to the level of the Japanese.

a. Who is likely to have the global competitive advantage? Consider, for example, the ability of GM to respond to
a Japanese attempt to gain U.S. market share through a sharp price cut.

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CHAPTER 16: CORPORATE STRATEGY AND FOREIGN INVESTMENT ANALYSIS

ANSWER. Even if GM manages to get its costs down to the level of its Japanese competitors, it will still face a
competitive disadvantage because of asymmetrical market shares. Suppose the Japanese cut their prices in order to
gain market share in the United States. If GM responds with its own price cuts, it will lose profit on 85% of its sales.
By contrast, the Japanese will lose profit on only 25% of their sales. This puts GM in a bind: If its responds to this
competitive intrusion with a price cut of its own, the response will hurt GM more than the Japanese.

b. How might GM respond to the Japanese challenge?

ANSWER. GM could reduce its costs still further through some major technological breakthroughs, by cutting wages
and benefits, or by sourcing more parts and components abroad. It could also improve its product differentiation in
ways that are valued by auto buyers. Alternatively, GM could cut price in Japan.

c. Which competitive response would you recommend to GM's CEO?

ANSWER. GM is actively engaged in various cost cutting activities and this activity should continue regardless of
what the Japanese do; it is not directly tied to their behavior. The second response--better product differentiation--is
problematic given GM's past history. The third alternative is the one to focus on. The correct place for GM to
retaliate against a Japanese competitive intrusion in the U.S. is Japan, where their competitors earn 40% of their
profits. This response would hurt the Japanese more than GM. But in order to make this retaliatory threat credible,
GM must build up its Japanese market position, a tall order for any U.S. firm.

2. Airbus Industrie, the European consortium of aircraft manufacturers, buys jet engines from U.S. companies.
According to a recent story in the Wall Street Journal, "as a result of the weaker dollar, the cost of a major
component (jet engines) is declining for Boeing's biggest competitor." The implication is that the lower price of
engines for Airbus gives it a competitive advantage over Boeing. Will Airbus now be more competitive relative
to Boeing? Explain.

ANSWER. This story reflects the same basic misunderstanding that we saw in an earlier problem dealing with the
competitive effects of dollar devaluation on the U.S. chemical industry (Chapter 11, problem 8). It is misleading
because engine prices are being measured in dollar terms for Boeing and European currency terms for Airbus. Since
the cost of engines, when measured in the same currency, is the same for both Boeing and Airbus currency changes
have no effect here. But other costs measured in the same currency will now be lower for Boeing than for Airbus.
Therefore, a falling dollar will place Airbus at a competitive disadvantage relative to Boeing.

3. Tandem Computer, a U.S. maker of fault-tolerant computers, is thinking of shifting virtually all the
labor-intensive portion of its production to Mexico. What risks is Tandem likely to face if it goes ahead with
this move?

ANSWER. If Tandem Computer shifts virtually all the labor-intensive portion of its production to Mexico it will face
several risks.

a) Quality control. Customers are buying its machines because they can't tolerate downtime. Tandem faces the
risk that it will be unable to ensure the same quality workmanship in Mexico as in the United States.

b) On time delivery. When a customer needs a machine, he needs it quickly. If there are border problems with
customs or delays on Mexican highways or railroads, Tandem may be unable to deliver machines on time to
customers. This makes it a less reliable supplier, which could hurt its sales.

c) Production disruptions. The Mexican government may at a later date restrict Tandem's ability to import
necessary machinery or parts, thereby forcing it to use Mexican products. This would disrupt production and
possibly lower quality standards as well. Labor strikes or lost or damaged shipments of materials would also disrupt
production.

d) Exchange risk. If the Mexican government insists on controlling the exchange rate, and not allowing the peso
to devalue in line with high Mexican inflation, the dollar costs of production in Mexico will rise.
 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

e) Political risk. The Mexican government may tamper with tax rates, sourcing of materials, shipments, customs
duties, and the like. Similarly, the U.S. may impose higher duties on labor-intensive imports from Mexico at the
instigation of U.S. labor unions seeking to stifle low-wage competition from Mexicans.

4. Germany's $28 billion electronics giant, Siemens AG, sells medical and telecommunications equipment, power
plants, automotive products, and computers. Siemens has been operating in the United States since 1952, but its
U.S. revenues account for only about 10 percent of worldwide revenues. It intends to expand further in the U.S.
market.

a. According to the head of its U.S. operation, "The United States is a real testing ground. If you make it here, you
establish your credentials for the rest of the world." What does this statement mean? How would you measure
the benefits flowing from this rationale for investing in the U.S.?

ANSWER. The U.S. has the largest, most advanced and most competitive market in the world for computer and
communications products. Many firms, including Siemens, believe it will be the driving force for further
development of these rapidly integrating technologies in the 21st century. Thus, the U.S. is a real testing ground in
that a company which succeeds here can succeed in the rest of the world.

Measuring these benefits is impossible to do with any precision. The recommended approach is to do the standard
net present value analysis ignoring these benefits. If the NPV is positive, then the U.S. expansion should be
undertaken regardless of the size of these benefits. A negative NPV, however, tells Siemens how large these benefits
must be to justify the expansion on financial grounds. Siemens's management must then decide how likely it is that
the benefits will be sufficiently large to yield a positive NPV project.

b. What other advantages might Siemens realize from a larger American presence?

ANSWER. Surviving in the tough American market, particularly in these days of unstable exchange rates and trade
restrictions, means getting as close to customers as possible. And that translates into local manufacturing. By
manufacturing locally, products can be shipped to the customer faster than if the seller depends on goods from a
source 3,000 to 7,000 miles away. The need for fast delivery has become even more pressing these days with the
trend among manufacturers toward maintaining low inventories, depending instead on "just-in-time" delivery from
suppliers. Customers are demanding quicker turnaround time between the order and delivery. But more than cost,
manufacturing locally is a way of being close to customers, capable of responding to their needs and demands and
able to provide service. Siemens U.S. also can export to the rest of Siemens the knowledge of how to do business in
the U.S. market, which could apply to many other markets.

5. Kao Corporation is a highly innovative and efficient Japanese company that has managed to take on and beat
Proctor & Gamble in Japan. Two of Kao's revolutionary innovations include disposable diapers with greatly
enhanced absorption capabilities and concentrated laundry detergent. However, Kao has had difficulty in
establishing the kind of market-sensitive foreign subsidiaries that P&G has built.

a. What competitive advantages might P&G derive from its global network of market-sensitive subsidiaries?

ANSWER. P&G can use its Japanese affiliate to copy Kao's innovations and then diffuse these innovations through
the global distribution network provided by its foreign subsidiaries. In general, P&G can take innovations in process
or product technology developed anywhere in the world and then apply them throughout the world. In this way,
P&G can achieve the economies of scale and scope associated with investing in a global distribution network. It can
also amortize its investments in technology across a global sales base, giving it a higher return for each dollar
invested in R&D and enabling it to invest more money profitably in R&D.

b. What competitive disadvantages does Kao face if it is unable to replicate P&G's global network of subsidiaries?

ANSWER. If Kao can't replicate P&G's market-sensitive global network of affiliates, it won't be able to exploit its
own innovations outside Japan. The inability to capture the full rents associated with its innovations means that
Kao's investment in new product and process technologies or in a global distribution system will be less profitable
than equivalent P&G investments, placing Kao at a competitive disadvantage relative to P&G.

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ADDITIONAL CHAPTER 16 PROBLEMS AND SOLUTIONS

1. More and more Japanese companies are moving in on what once was an exclusive U.S. preserve: making and
selling the complex equipment that makes semiconductors. World sales are between $3 billion and $5 billion
annually. The U.S. equipment makers already have seen their share of the Japanese market fall to 30% recently
from a dominant 70% in the late 1970s. Because sales in Japan are expanding as rapidly as 50% a year,
Japanese concerns have barely begun attacking the U.S. market. But U.S. experts consider it only a matter of
time.

a. What are the possible competitive responses of U.S. firms?

ANSWER. The standard response by U.S. firms is to spend more money on R&D to further differentiate those
products in which they are no longer cost competitive. Another approach is for U.S. companies to build up their
market presence in Japan to deny their Japanese competitors the rapid expansion in sales and protected profit
sanctuary that enable them to be such formidable competitors elsewhere in the world. Exposure to the
extraordinarily high quality standards set by Japanese industry will also improve the competitiveness of U.S. firms.

b. Which one(s) would you recommend to the head of a U.S. firm? Why?

ANSWER. It is not an either/or issue. To the extent that U.S. firms have a competitive advantage in developing
technology, they should continue to invest in R&D. But they should also consider the strategy followed by their
Japanese competitors. In fact, according to the Wall Street Journal (January 9, 1985, p. 34), "U.S. semiconductor
manufacturers think they are better-prepared than the machine tool makers were. Several already are setting up
manufacturing plants in Japan to compete more effectively." U.S. companies are also more willing to modify their
equipment and are trying to provide better service for customers.

2. Nordson Co. of Amherst, Ohio, a maker of painting and glue equipment, exports nearly half its output.
Customers value its reliability as a supplier. Because of an especially sharp run-up in the value of the dollar
against the French franc, Nordson is reconsidering its decision to continue supplying the French market. What
factors are relevant in reaching a decision?

ANSWER. The problem tells us that customers value Nordson's reliability as a supplier. If Nordson cuts and runs in
France, other customers will take it as a signal as to how it is likely to respond elsewhere when the going gets tough.
This will hurt Nordson's sales to customers in other countries.

Nordson must also consider the chance that at some point in the future the dollar will decline, making it more
profitable to service the French market. But if it exits the market now, reentry at a later date will be especially
difficult. In addition to dealing with customer ill will, Nordson will have to rebuild its distribution and service
network. Thus, exiting the market today will destroy a valuable option to sell in the French market when the dollar
turns down.