CHAPTER 15

LICENSING, FRANCHISING AND OTHER CONTRACTUAL STRATEGIES

I. LECTURE STARTER/LAUNCHER
 This chapter discusses types of contractual relationships and their role in
international business. Coverage is given to licensing and franchising, and other
arrangements as well. Much of the focus is on intellectual property, and what
managers should do to protect it. Students learn that licensing, franchising, and
other types of contracts, are common in international business.

 Ask students to name companies that franchise or license their services abroad.
You can refer them to Chapter 3 which highlights some leading international
franchise stores. Students in the United States may be surprised to learn that one in
every 12 retail establishments is a franchise business. Students will probably name
McDonald's, Subway, KFC, and Starbucks as examples of franchise store
organizations. You can ask students to quickly research those companies to verify
that they have used franchising arrangements as part of their international
expansion. For example, McDonald’s has far more restaurants abroad than they do
in their home market, the United States. This can be verified at the McDonald’s
website, www.mcdonalds.com. KFC is one of the leading franchisors in China.

 You can explain to students that the overall category of entry strategy addressed in
this chapter is contracts relationships, with licensing and franchising agreements as
two of the most common types. A franchise agreement allows a franchisee, or in this
case, the host country firm, the right to use an entire business system provided by
the franchisor.

 Franchisors include many types of service firms, such as rental car companies,
document delivery companies, muffler shops, retail clothing stores, and cosmetics
stores. Franchising allows such businesses to internationalize rapidly and efficiently.

 Contractual agreements involve a moderate level of risk and return, compared to

exporting, which has relatively lower risk and lower returns, while foreign direct
investment may involve higher risk and higher returns.

 The instructor may draw on the board a graph, with the horizontal axis representing
risk or cost, and the vertical axis representing potential return, and a diagonal,
gradually rising line showing a positive direct relationship. "Exporting" would appear
on the far left of the line, "foreign direct investment" on the far right side of the line (in
the upper right corner), "joint venture” just a bit to the left of foreign direct
investment, and "contractual arrangements" somewhere between exporting and joint
ventures. This will show the generally linear relationship between risk and return of
these four types of entry strategies.
II. LEARNING OBJECTIVES AND THE OPENING VIGNETTE

Learning objectives:
1. The nature of contractual relationships in international business
2. Licensing
3. Advantages and disadvantages of licensing
4. Franchising
5. Advantages and disadvantages of franchising
6. Other contractual entry strategies
7. Management of licensing and franchising

Key Themes
 The key themes in Chapter 15 are the nature of contractual relationships, their
various types, advantages and disadvantages, and what managers might do to
mitigate the risks of these contractual arrangements. While most of the discussion is
about licensing and franchising, other contractual strategies are also discussed,
such as turnkey contracts, build-operate-transfer arrangements, management
contracts, complementary marketing, and leasing. Finally, there is a discussion
about managing these arrangements, with an emphasis on intellectual property
protection.

Teaching Tips
 The chapter includes many excellent examples of contractual arrangements, and the
instructor can take advantage of them by asking students to research them further.
Students learn that, in certain industries, licensing, franchising and other contractual
arrangements are popular internationalization strategies.

 For example, ask students to research how McDonald’s Corporation has expanded
internationally. In some cases, McDonald's has developed company-owned stores.
In other countries it has used the franchising model. Ask students to think about
why McDonald's chose these different formats in different countries. They might
mention that in Russia in 1990, McDonald's wanted significant control of its first
restaurant in that country, and agreed to form a joint venture with Russian partners.

 Ask students to research companies in their city, metropolitan area, or region that
have expanded internationally using a contractual agreement. For example, many
manufacturing companies have entered into manufacturing contracts with
contractors in China, Eastern Europe and Mexico. These latter firms manufacture
products to the specifications of the focal firm, either for export back to the focal
firm’s country, for export to third countries, or for sale in local markets. Students
can research companies using Hoovers.com, Standard & Poor’s, Merchant Online,
and company websites to learn about their experience using contracts for
internationalization. They can also find articles in the business press, including the
Financial Times, Wall Street Journal, and Business Week that discuss the ventures.
Commentary on the Opening Vignette: Harry Potter: The Magic of Licensing

 Key message
This vignette highlights the pros and cons of contractual agreements using the Harry
Potter franchise as an example. The media company Warner Bros. has exclusive
licensing rights for Harry Potter. It licenses with many types of companies worldwide to
produce food products, toys, clothing, and home furnishings with the Harry Potter name
or image.

 Uniqueness of the situation described

Warner's licensing of Harry Potter has advantages and disadvantages. Warner uses
restraint by not licensing to just any firm to protect the Harry Potter brand.
Nevertheless, there are dangers of piracy, if firms in other countries use the licensed
item to generate sales without permission of the owner of the intellectual property. This
is not a danger unique to licensing, however. In countries such as China, where
intellectual property rights have been slow to develop, piracy is a risk for any company
doing business there.

 Classroom discussion
Ask students what they think about intellectual property protection. Should Warner work
hard to protect their rights to the Harry Potter brand? How should they do it? Should
they obtain patent or copyright protection in every country where Harry Potter products
are licensed? Ask students if they've ever purchased a pirated copy of a DVD,
computer software, or CD. Ask if they've ever downloaded music from the Internet. Do
they think this is a violation of intellectual property rights? Do they think it is ethical?
Emphasize that these are two separate issues: the legality versus the ethicality of the
action.

III. DETAILED CHAPTER OUTLINE

INTRODUCTION
 The opening vignette is titled Harry Potter: The Magic of Licensing. See the
commentary, above.

THE NATURE OF CONTRACTUAL RELATIONSHIPS IN INTERNATIONAL

BUSINESS
 Begin teaching this chapter, by referring to contractual relationships as a general
category of agreements for cross-border business. Cross-border contracts permit a
foreign partner to use a focal company’s intellectual property in exchange for a
continuous stream of payments.

 The way that the intellectual property is used depends on the details of the contract.
The contract also controls the money transfers. Therefore, the strength of contract
law in the host country becomes an important factor in a licensing deal.
 Remind students that intellectual property consists of ideas, brands, products, or
other work created by people or companies that are protected by patents,
trademarks, and copyrights. Explain that cross-border contractual agreements have
six common characteristics:
 They are governed by a contract.
 They involve the exchange of intellectual property and services.
 They can operate independently or together with other modes of entry.
 They allow firms flexibility.
 They often reduce the liability of foreignness for the focal firm.
 They generate a predictable level of earnings through royalties.

LICENSING AGREEMENTS
 A license allows a firm to use the intellectual property for a specified period of time in
exchange for royalties. Licensing allows the licensee to legally produce and sell a
product similar to that produced by the licensor in the home country. This usually
involves an exclusive agreement meaning that the licensee is not permitted to share
the licensed asset with any other company within a prescribed territory.

 Sometimes the licensee may be permitted to export to third countries, but this must
be specified. A licensor may develop a licensing agreement with its own wholly
owned subsidiary or joint venture. This may seem cumbersome, but it allows the
foreign affiliates to use intellectual property within a formal legal framework. It is
typically used when the foreign affiliate is a separate legal entity. This means
licensing can be a supplementary strategy to foreign direct investment.

 Licensing is common in the fashion industry. Brands such as Bill Blass, Hugo Boss,
and Pierre Cardin license, clothing, fragrances, and jewelry. Many food products are
produced locally through licensing agreements. Evian bottled water is owned by the
French company Danone, but it is licensed to the Coca-Cola Company in the United
States. Caterpillar, the earth-moving equipment company, and Harley Davidson, the
motorcycle company, license their trademark names to a Michigan footwear
company called Wolverine World Wide (WWW). WWW then produces boots and
fashion footwear using the Cat and Harley brands, under strict specifications from
those two companies.

 Know-how agreements involve the transfer of technological or management

knowledge about how to design, make, or deliver a product or service. These are a
bit different from other licensing agreements. For example, AT&T, Intel, and
Siemens used know-how agreements to license their patents to each other,
accelerating innovation in semiconductors. In the pharmaceutical industry, leading
drug firms may license inventions to each other to help develop new generations of
drugs.

 The Exhibit lists leading licensors ranked by licensing revenues, 2005. Students
may be amazed to see that Disney generates US $21 billion for toy and apparel
licensing of Disney characters.
 The next Exhibit highlights advantages and disadvantages of licensing, from the
licensor’s viewpoint.

 Principal advantages include reduced capital investment, royalties generated by

existing intellectual property, reduced political risk, provides a test market
environment, and avoids certain government regulations.

 Disadvantages include modest revenues, low control over the licensee, risk of
losing intellectual property to piracy, reduced chances of expansion,
inappropriate for intellectual property that represents a core competency, and
complicated dispute resolution.

FRANCHISE AGREEMENTS
 Franchising is a more complex form of licensing in which the franchisor allows a
franchisee the right to use its entire business system in exchange for royalties.
Similarly, explicit contracts define franchising relationships. Franchising is common
in international retailing: organizations such as Benetton, The Body Shop, Yves
Rocher, and Marks & Spencer are examples.

 A typical arrangement is called business format franchising. The franchisor transfers

a total business method to the franchisee, including production, sales, standard
operating procedures, management know how, the use of its name, patents, and
trademarks.

 In addition to paying royalties, the franchisee must purchase equipment and supplies
from the franchise or to ensure uniform quality. The franchising agreement may
involve leasing property to the franchisee, which is the case with a McDonald's
franchise.

 While licensing agreements are relatively short, franchising agreements tend to be

long term. Franchising tends to be a more stable, long-term strategy, and it gives
the franchisor more control.

 A master franchise agreement is a variant of the franchising method. In this case,

the franchisor licenses an independent company in the foreign country to establish,
develop, and manage all franchisees in its market. The master franchisee then sub-
franchises other businesses and becomes the local franchisor. This may be
convenient for the focal firm from an operational point of view, however it gives up
significant control when it does so.

 The US is home to the largest number of franchisors and dominates international

franchising. US franchisors and franchisees represent about US $1 trillion, or about
40%, of total US retail sales. The Exhibit shows advantages and disadvantages of
franchising, from the point of view of the franchisor.
  Advantages include a quick and cost effective method of expanding to many
foreign markets, little capital investment needed, establishes brand name sales
potential early, and the ability to leverage franchisee knowledge in local markets.

 Disadvantages include potential difficulty controlling franchisees, potential

conflicts including legal disputes with franchisee, preserving franchisor’s image,
requires assistance, monitoring, and evaluation, and the chance that franchisees
may become future competitors.

 The next Exhibit shows advantages and disadvantages of franchising, to the

franchisee.

 Advantages include gaining a well known brand name, acquiring training, know-
how, and support from franchisor, operating an independent business, become
part of an established international network.

 Disadvantages include a high initial investment, high royalty payments,

franchisee must purchase supplies from franchisor only, franchisor holds superior
bargaining power, franchisor may license to other franchisees creating
competition, and franchisor may impose inappropriate systems (especially in the
international context) on the franchisee.

OTHER CONTRACTUAL ENTRY STRATEGIES

 Turnkey contracting. In this arrangement, the focal firm plans, finances, organizes,
manages, and implements all phases of the project abroad. Then, it turns it over to
a host country customer, usually after training local personnel.

 Examples include transportation systems such as subways, bridges, roadways,

airports, harbors, refineries, hospitals, and railways. This type of contractual
agreement facilitates international growth for firms in many service industries.
Construction, engineering, architectural, and design firms have become major global
players due to turnkey and other contractual arrangements.

 Build -- operate -- transfer arrangements, known as BOT, is similar to turnkey

arrangements. However, the contracting firm operates the facility for a specific time,
and then transfers ownership to the local project sponsor.

 Management contracts. In this case, a contractor supplies managerial knowledge to

operate a hotel, resort, hospital, airport, or other facility in exchange for
compensation. The contractor runs the facility without actually owning it. Much of
Disney's income from its French and Japanese theme parks comes from its
provision of management services to the parks. Disney does not own those parks:
rather, it provides management services to them.

 Complementary marketing. Also known as piggyback marketing, one firm distributes

another firm’s product in a foreign country in exchange for compensation. Usually
 the piggybacked product complements, rather than competes with, the local firm’s.
Mattel Toy Company has a contract with Avon in China to market its toys there.
Readers Digest has a contract with Avon in Australia, Canada, and New Zealand to
market magazine subscriptions there.

 Leasing. The focal firm, called the lessor, rents machinery or equipment to clients
abroad, called the lessee. The lessor retains ownership of the property and receives
lease payments from the customer overseas. This can reduce the cost of a project
since the lessee may not need to own the equipment. Several large companies
lease aircraft to both large and small airline companies worldwide. For example,
Virgin Express leases airplanes from Dubai-based Oasis Leasing.

INTERNATIONALIZATION OF PROFESSIONAL SERVICE FIRMS

 We've discussed how some service firms such as engineering, architectural, and
construction can internationalize through contractual arrangements. Other service
firms, including accounting, advertising, consulting, legal, information technology,
and security have internationalize quickly by following their clients to the markets
where they operate.

 Service firms encounter unique challenges. Regulations in foreign countries may

restrict the ability of foreign firms to practice law, medicine, accounting, or dentistry if
the foreign firm must send professionals to the host country. Finally, the delivery of
these services usually requires excellent language and cultural skills.

 Professional service firms use both foreign direct investment as well as contractual
arrangements to expand into global markets. The Global Trend case on the
management consulting industry focuses on McKinsey & Co.. Students may be
surprised to learn that management consulting became international in the 1950s,
after World War II.

RECENT GRAD IN IB: JENNIFER KNIPPEN

Sales Engineer, KONE Worldwide, Inc., Helsinki, Finland.
 Jennifer started her IB career with a dual degree in economics and international
business and participated in a study abroad program in Spain.
 As a sales engineer for the Finnish manufacturer of elevators and escalators,
KONE, Inc., she has faced challenges dealing with strict US building codes and
fluctuations in the dollar-Euro exchange rates as they affect sales.

THE MANAGEMENT OF LICENSING AND FRANCHISING

 Although contractual arrangements provide advantages to companies wishing to find
a more moderate dose of risk and return, licensing and franchising are complex
deals that require skillful, prior research, planning, and execution.
 This returns us to the basics of international business. Firms must always do
appropriate research on the host country, the industry, and conduct due diligence on
the firms with which they will contract.

 Selecting qualified partners may be the most critical success factor in contractual
arrangements. Qualified franchisees usually have:
 Entrepreneurial drive.
 Access to capital and real estate.
 Successful business track record.
 Good relationships with local government.
 Good relationships with other firms.
 Motivated employees.
 Willingness to accept contractual oversight and focal company procedures

INTELLECTUAL PROPERTY
 Protecting intellectual property can be a major challenge in international contractual
arrangements.
 First, legal systems in other countries do not always protect contracts in the
same way they are protected in the West.
 Second, conflicts may arise due to cultural and language differences.
 Third, contract enforcement may be costly or impractical. Therefore, in
addition to a strong contract, focal firms should develop a close, trusting
relationship with foreign partners to help mitigate the risk of IP infringement.

 Infringement of intellectual property, or piracy, occurs when someone engages in

unauthorized use, publication, or reproduction of products or services that are
protected by a patent, copyright, trademark, or other intellectual property rights. The
total value of counterfeit and pirated goods worldwide is about US $600 billion, or
about 5% of the US GDP.

 Two phenomena may exacerbate piracy in international business.

 The first is the Internet and other information technology that attract users to
illegal sites.
 The second is the increased ability of individuals in emerging market
countries to engage in piracy, inversely related to those countries’ weak IPR
enforcement. SMEs are particularly vulnerable to IPR crimes, because they
often don't have resources to pursue violators.

A REVIEW OF INTELLECTUAL PROPERTY PROTECTION

 Key treaties include:
 The Paris Convention for the protection of industrial property.
 The Berne Convention for the protection of literary and artistic works.
 The Rome Convention for the protection of performers and broadcasting
organizations. All three are administered by the World Intellectual Property
organization, or WIPO, an agency of the United Nations.
  The World Trade Organization, or WTO, administers the Agreement on Trade
Related Aspects of Intellectual Property Rights, or TRIPS. TRIPS is the most
comprehensive international agreement on intellectual property to date.
Violators may be disciplined through the WTO's dispute resolution system.

 Countries that are not signatories to WIPO or TRIPS are the most risky from an IP
perspective. A company that obtains a patent, trademark, or copy right in one
country is not protected in another country. IPR enforcement therefore is local, and
every new country requires new IPR protection.

 The chapter closes with 12 guidelines for managers that may help reduce the
likelihood of IPR violations in international expansion.

 It is suggested that a good way to combat piracy is to be competitive through

innovation and technological superiority.

 Then, when IPR violations occur, the stolen intellectual property will soon become
obsolete.

IV. CLOSING CASE

Subway and the Challenges of Franchising in China

 Summary

The case discusses Subway’s efforts to expand into China. Subway is a US fast food
marketer, and the third largest of its kind in China. The company has had significant
challenges, and the case discusses these as well as the benefits of franchising in
China. Many of the same issues that affect any international expansion affect
franchisors in China: the ambiguous legal environment, a lack of intellectual property
protection, and high startup costs.

 Suggested solutions to questions

1. Subway brings to China various intellectual property in the form of trademarks,

patents, and an entire business system. What are the specific threats to Subway’s
intellectual property in China? What can Subway do to protect its intellectual
property in China?

Intellectual property protection in China is weak, and franchisors such as Subway must
carefully protect their trademarks. For example, a local imitator might create another
sandwich shop with a menu and a storefront look similar to Subway’s. Branding is
important and can create customer loyalty, however imitators have successfully created
copycat logos and storefronts. The case notes that Starbucks was imitated by a
Shanghai coffee shop that copied its logo and name. Another example is the Chinese
hamburger chain called “Merry Holiday” that used a yellow color scheme and
emphasized the letter “M,” similar to McDonald's.

One way Subway can protect its intellectual property is to engage with strong, reliable
partners. Negotiating a strong, explicit contract is a necessary but insufficient step, as it
may not protect the company in China as well as it might in the United States due to
weaker contract laws. Management should strengthen the partner relationship by
providing a high level of trust and trustworthiness through resources and support.
Regarding piracy of intellectual property, there are some regulatory systems and
methods of recourse. International treaties such as the Paris Convention, the Berne
Convention, and the Rome Convention are administered by the World Intellectual
Property Organization, and may provide some relief. Recently, the Agreement on Trade
Related aspects of Intellectual Property Rights, or TRIPS, was negotiated as part of the
World Trade Organization. All WTO members – including China -- are under strong
pressure to comply with these intellectual property rules. Therefore, with strong partner
relationships and the recourse of invoking international agreements, Subway may be
able to protect its intellectual property

2. What do you think about Subway’s method and level of compensating its
master franchisee and regular franchisees in China? Is the method satisfactory?
Is there room for improvement?

Evidence suggests that Subway’s model and level of compensation for its franchisees in
China is satisfactory. The case is not specific, but it notes that many franchisees have
become successful, albeit after some early losses, and that many new stores are under
construction. There is always room for improvement. The case notes that franchisees
experience problems due to a relative lack of credit from banks and difficulties
purchasing real estate. However, the case notes that Chinese banks are increasingly
open to financing franchise operations, and that new construction of shopping malls
have become good locations for franchised restaurants.

3. What are the advantages and disadvantages of franchising in China from Jim
Bryant’s perspective? What can Bryant do to overcome the disadvantages? From
Subway’s perspective, is franchising the best entry strategy for China?

A big advantage to franchising in China is the size of the market: the fast food market
there is about $15 billion per year. China's urban population, which is the target market
for casual dining, has expanded 5% per year and is expected to continue. Busier
lifestyles have led to an increase in people taking meals outside of the home, and
Chinese consumers seem to be interested in sampling non-Chinese foods. Another
advantage is the apparent entrepreneurial spirit of the Chinese which indicates high
growth for franchise models such as Subway’s. Although the initial startup fees may
seem steep (US $10,000), similar arrangements with famous international franchised
brands such as McDonald's, A & W, Dunkin' Donuts, and Rainforest Café have created
successful businesses for many Chinese franchisees.
4. Subway faces various cultural challenges in China. What are these challenges
and what can Subway and its master franchisee do to overcome them?

Cultural challenges at the macro or institutional level include limited financing of

franchisees by Chinese banks, limits on real estate purchases, protection of intellectual
property, finding appropriate partners, repatriation of profits, and high startup costs..
Cultural challenges at the micro or customer level include constantly adapting offerings
to local tastes while providing unique and interesting products to customers, initial lack
of customer familiarity with sandwiches, and loss of business to competition from
potential copycat or pirated restaurants. As noted above, Subway should always select
strong, reliable partners, provide them with strong support, invoke intellectual property
recourse as necessary, and continually monitor the market for changes in consumer
behavior.

V. END OF CHAPTER QUESTIONS

TEST YOUR COMPREHENSION

1. Distinguish between the major types of intellectual property: trademarks,

copyrights, patents, industrial designs, and trade secrets.

Students should be able to explain what types of property each designation one
protects. For example, patents protect an invention or process. Trademarks protect a
design, symbol, word, or brand. A copyright protects works authored by others.
Industrial design protects the appearance or features of a product. A trade secret is
confidential know-how.

2. What are the major characteristics of licensing? What are the major
characteristics of franchising?

Students should note a license usually involves a specific time period and a specific
country or region. See the Exhibit. The licensor provides intellectual property and/or
supporting products. The licensee compensates the licensor either through a lump sum
payment, a down payment plus royalties. Franchise agreements are similar to license
agreements, but are usually longer term. The franchisor transfers a total business
method to the franchisee, including production, sales, standard operating procedures,
management know how, the use of its name, patents, and trademarks. The franchisee
pays royalties, purchases equipment and supplies from the franchise or to ensure
uniform quality, and may lease property to the franchisee.

3. What are the advantages and disadvantages of licensing?

Students should explain the material in the Exhibit titled "Advantages and
disadvantages of licensing to the licensor."
4. What are the advantages and disadvantages of franchising from the
perspective of franchisors and franchisees?

Student should explain the material in the Exhibit titled "Advantages and disadvantages
of franchising to the franchisor." Then, they should explain the next Exhibit titled
"Advantages and disadvantages of franchising to the franchisee."

5. What industry sectors are more likely to rely on franchising to tap foreign
markets?

Franchising is very common in international retailing. Students should refer to the

Exhibit, a chart of leading international franchise orders. Industries include
professional business services, home improvement products and services, automotive
products and services, education services, lodging, entertainment, and recreation, fast
food, restaurants, health, medical, and beauty care, cleaning and household services,
and retailers.

6. Define and distinguish the following contractual entry strategies: build-

operate-transfer, turnkey projects, management contracts, complementary
marketing, and leasing.

For each type of contractual entry strategy, the text includes a box explaining its
characteristics. Students might try creating a chart with several columns outlining the
type of contractual entry strategy, the type of service provided by the focal firm, who is
responsible for operation, and perhaps divide that into short-term and long-term. By
creating a chart, students may get a better visual handle on the differences among the
type of arrangement.

7. What are best practices in managing international contractual relationships?

Best practices include carefully selecting qualified partners, and safeguarding

intellectual property. These are covered in significant detail in the chapter and students
should explain how this could be done.

8. Suppose you work for a firm that holds valuable intellectual property and is
contemplating various international business projects. What strategies would
you recommend to management for protecting its intellectual property?

One disadvantage of management contracts is that after working with foreign firms, the
foreign firms may become competitors. The biggest concern, then, is protecting
intellectual property. There are 12 guidelines listed that should help managers reduce
the likelihood of IPR violations.
APPLY YOUR UNDERSTANDING

1. The licensing of intellectual property is now a global business. As revealed in

the opening vignette, Warner Bros. (‘Warner’) is doing a thriving business by
licensing images of Harry Potter on its manufactured products, such as software
games and clothing. However, safeguarding intellectual property is the real
challenge in many countries. Illicit operators worldwide produce their own
books, shirts, games, and other products that feature the Potter image ─ without
entering a licensing agreement with Warner. What steps can Warner take to
address this problem? That is, what types of strategies can Warner use to
protect Harry Potter from intellectual property infringement around the world?

As discussed in questions 7 and 8 above, Warner should carefully select its partners in
foreign countries, and do everything it can to protect its intellectual property. With
regard to intellectual property violations, Warner should review the twelve points
outlined in the chapter. This includes understanding local intellectual property laws,
registering its trademarks and copyrights, drafting contracts such that intellectual
property is used as is intended, monitoring for infringement, guarding trade secrets,
training employees, using non-compete clauses, using technology to reduce
counterfeiting, and continuously innovating technologies and products.

2. In addition to licensing and franchising, there are various other contractual

entry strategies. Suppose upon graduation you get a job with Hitachi America,
Ltd. (www.hitachi.us) -- the U.S. subsidiary of the giant Japanese firm. Hitachi is
involved in various contractual entry strategies in its international operations:
Build-operate-transfer and turnkey projects in the infrastructure development
sector; Management contracts to run nuclear power plants; and leasing of heavy
earth-moving equipment to foreign governments. Suppose that Hitachi America
wants to extend its reach into Latin America. Prepare a report for your senior
managers in which you explain the various ways for Hitachi to implement these
entry strategies.

Students should first describe Hitachi America’s business. Hitachi America, Ltd. markets
and manufactures electronics, computer systems and products, IT services and
industrial equipment and services throughout North America. Second, students should
describe why Latin America is appropriate for Hitachi America's expansion. Reasons
include its proximity to the United States, needs in the region generally for these kinds
of products, and healthy competition with other national and international firms. Third,
students could apply each of the four types of contractual arrangements to one or more
of Hitachi's products and services.

For example, Hitachi America could propose a turnkey project to plan, finance,
organize, manage, and implement all phases of an infrastructure development project
for a Latin American country’s Ministry of Transportation. Under a turnkey contract,
Hitachi would hand the project ownership to the Ministry, after training local personnel.
Alternatively, Hitachi America could propose a build -- operate -- transfer (BOT)
arrangement. Hitachi would play the same role, however instead of delivering the
completed facility to the Ministry immediately, Hitachi would operate it for several years
before transferring ownership to the Ministry. Under a management contract, Hitachi
would provide the managerial know-how to the Ministry of energy by providing
management services to it in exchange for compensation. This would be useful if the
host country lacks the experience of running a nuclear power plant. Finally, Hitachi may
lease heavy equipment to the host country agency, retaining ownership of the property
and receiving regular payments from the host country’s Ministry. In this way; the
Ministry has access to top quality equipment at a convenient price. Hitachi has quick
access to target markets, and may generate significant profits because it avoids certain
types of taxes and regulations.

3. Suppose you own a ’flying doctor’ business in Australia in which you employ
physicians to travel by airplane to ranches and rural communities in Australia’s
outback, to care for the sick and wounded. Your business has thrived, and
you’ve been able to add numerous employees. You’ve decided that, given your
success, you can extend your service to rural areas in the Asia-Pacific region
beyond Australia. There are numerous nations in Southeast Asia and the South
Pacific characterized by population concentrated in remote areas, much of which
is underserved by medical care. There are various ways to internationalize
professional services, including licensing, franchising, and FDI. For the
professional services sector, differentiate between these three entry strategies:
(a) what are the advantages and disadvantages of each? (b) What are the main
differences between franchising and FDI?

(a) Students may create a chart showing advantages and disadvantages of each
type from the licensor, franchisor, and investor viewpoint:

Advantages
Licensing  Licensor provides little capital
investment and presence in foreign
market
 Royalty income generated from
existing intellectual property
 Good for entering markets with
substantial political risk
 Good alternative when trade
barriers reduce attractiveness of
exporting, or when governments
restrict ownership of operations by
foreign firms
 Useful for testing a foreign market
prior to entry via FDI
 Useful as a strategy to pre-
emptively enter a market before
rivals
Disadvantages
 Revenues usually more modest than
other entry strategies
 Difficult to maintain control over how
the licensed asset is used
 Risk of losing control of intellectual
property or dissipating it to competitors
 Licensee may exploit licensor’s
intellectual property and become a
competitor
 No guarantee of future expansion in
the market
 Not recommended for products,
services, or knowledge that are very
complex
 Complex dispute resolution
Franchising  Expansion to numerous foreign
markets is quick and cost-effective
 No need to invest substantial capital
 Brand name encourages early and
ongoing sales potential abroad
 Firm can leverage franchisees’
knowledge to efficiently navigate
and develop local markets
 Controlling franchisee may be difficult
 Conflicts with franchisee are likely,
including legal disputes
 Preserving franchisor’s image in the
foreign market may be challenging
 Must provide ongoing assistance,
monitoring, and performance
evaluation of franchisees
 Franchisees may take advantage of
acquired knowledge and become
future competitors

FDI  Knowledge transfer is relatively  Management structure more complex

easier  Coordination with HQ may be a
 Common goals drive the business concern
venture  High exit barriers
 Greatest level of control  Greater exposure to political risk
 Implies local presence and  Greatest risk and uncertainty
operations  Greatest resource commitment
 Allows firm to achieve global scale
efficiency

(b) Students can refer to the chart that they just created. They should also refer to
Chapter 14 for facts on FDI, and Chapter 15 for facts on franchising.
Franchising may be most useful when the entire business system can be
transferred with little threat of intellectual property infringement. FDI, which
gives greater control to the focal firm, may be necessary when proprietary
knowledge and information must be protected. Students can look at the case of
retailers, who typically choose between FDI and franchising. Larger, more
experienced companies tend to expand through FDI. They want to own their
own stores and have a high level of control. Smaller and less experienced firms
may rely on networks of independent franchisees. Franchising provides a fast
way to internationalize, but it gives the firm lost control over its foreign
operations than FDI does.

globalEDGE™ INTERNET EXERCISES (globaledge.msu.edu)

1. You have just started working in the office of the International Intellectual
Property Alliance (IIPA; www.iipa.com). You learn that worldwide piracy of
products is rampant. Your boss assigns you the task of drafting a brief policy
memo in which you address the following questions:
a. What is the worldwide scope of piracy? What industries are most
affected by piracy, and what is the financial loss from piracy in each of
these industries?
b. What are the top five countries that are the greatest sources of piracy?
c. What strategies do you recommend for combating piracy?
In addition to globalEDGE™ and IIPA portal, other useful sites for this exercise
are the Office of the United States Trade Representative (www.ustr.gov), United
Nations (www.un.org), and the Business Software Alliance (www.bsa.org).

Piracy is a major worldwide trade problem that crosses all borders. The industries most
affected are Business Software, Records & Music, Motion Pictures, Entertainment
Software, and Books. In 2006 the top five countries in terms of estimated trade losses
due to copyright piracy were China (US$2,207 million), Russia ($2,180 million), Italy
($1,431 million), Mexico ($1,006 million), Japan ($909 million). Strategies for combating
piracy are described next. Governments should sign copyright treaties, which lead to
the creation of national laws. Create reports that illustrate how a country will financially
benefit from enforcing copyright laws, so that nations are compelled to implement piracy
laws. Our firm should invest in anti-piracy measures, including: (i) Understand local
intellectual property laws and enforcement procedures; (ii) Register patents and other
such assets with the government in each country where we do, or intend to do,
business; (iii) Ensure that our licensing and franchising agreements provide for
oversight to ensure intellectual property is used as intended; (iv) Include a provision in
licensing contracts that requires the licensee to share any improvements or
technological developments on the licensed asset with the licensor; (v) Pursue
infringers according to the law; (vi) Monitor franchisee, distribution, and marketing
channels for any asset infringements; (vii) Guard trade secrets closely; (viii) Train
employees to use registered assets correctly and to preserve desired protection levels;
(ix) Include non-compete clauses in employee contracts for all positions to prevent
employees from serving competitors for up to three years after leaving the firm; (x) Use
contemporary technology to minimize piracy; (xi) Continuously update technologies and
products, and differentiate products by developing a strong brand name, in order to stay
‘one step ahead’ of counterfeiters.

2. Suppose you are an international entrepreneur and want to open your own
franchise somewhere in Europe. You decide to conduct research to identify the
most appropriate franchise and to learn how to become a franchisee.
Entrepreneur.com publishes an annual list of the top 200 franchisors seeking
international franchisees. Visit www.entrepreneur.com for the list or search for
“franchising” at globalEDGE™. Choose the franchise that interests you most (for
example, Subway, ServiceMaster, Century 21), and visit its corporate website.
Based on information from the website, as well as globalEDGE™ and
Hoovers.com, address the following questions:
a. How many franchised operations does this firm have outside its home
country?
b. What are the major countries in which the firm has franchises? Are
there any patterns in terms of the countries where this firm is established?
c. According to the application information provided at the corporate site,
what qualifications is the firm seeking in new franchisees?
d. What types of training and support does the firm provide for its
franchisees?
Example: Domino’s Pizza LLC
a. Foreign Franchises: 3,223
b. Australia, Canada, Japan, Britain, France, Italy, Germany, China, Mexico, Argentina.
The firm appears to mostly target countries with advanced economies and high levels of
consumer affluence. Mexico was probably targeted because it is next door to the United
States, Domino’s home country. China was probably targeted because of its huge
population base.
c. Qualifications: Minimum of 1 year management experience. The firm provides
support for completion of Pizza Prep School, Franchise Development Program and in-
store training. A minimum of $75,000 in liquid capital, minimum of $250,000 in net
worth, and strong credit history is required. Approved franchisee must retain at least
51% ownership at all times and oversee store operations. Franchisees cannot have
business interests outside of their franchise location(s) with Domino's Pizza. Good
driving record, good credit, no bankruptcies, U.S. citizenship or the ability to legally work
in the U.S.
d. Training & Support: Domino’s Pizza offers training at the headquarters for 6-8
weeks and helps with the site selection and construction of a new franchise. Ongoing
support includes: newsletter, meetings, grand opening, internet, security/safety
procedures, field operations. Market support includes: co-op advertising, ad slicks, and
national media.

3. The International Licensing Industry Merchandisers' Association (LIMA;

www.licensing.org) is an organization with offices worldwide. It fosters the
growth and expansion of licensing by helping members network, educating
members about licensing, and establishing standards of ethical and professional
conduct in intellectual property licensing. Suppose you work for a small
animation company that has developed several popular cartoon characters that
have licensing potential, in the same way that Disney licenses its cartoon
characters. Management would like to learn more about becoming a licensor of
its cartoon characters. To begin licensing the characters to interested garment
makers, school supply manufacturers, and similar firms, visit the LIMA website
and write a memo that addresses the following:
a. Who are the major members of LIMA?
b. What are the major trade shows that your firm can attend to exhibit its
licensable products and learn more about licensing?
c. What types of seminars and training are available to learn more about
becoming a licensor?
d. Based on the information provided at the site, what can you learn about
anti-counterfeiting activities and challenges in licensing?

a. The majority of LIMA’s members are managers and other employees working at
licensing departments of major corporations.
b. The major trade shows that our firm can attend are:
• Brand Licensing London 2007 (Trade Show Management)
• CG Kommunikation (Event Marketing Trade Show Management)
• George Little Management, LLC (Trade Show Management)
 • Dubai International Character & Licensing Fair (Trade Show Management)
c. Seminars and training available to learn more about becoming a licensor are:
• LIMA's Certificate of Licensing Studies
• LIMA Educational Programs
• Conferences & Seminars & Presentations
• Licensing University
d. In the era of globalization, licensing has changed from domestic to international.
Entering into a new region entails understanding different cultures, linguistics, and
consumer behavior. Licensors need to be aware of different political and economic
arenas in different regions, as well as, have knowledge about the legal, financial and
market structures. The site provides numerous suggestions on how to combat
counterfeiting and other intellectual property violations in licensing.

VI. C/K/R MANAGEMENT SKILL BUILDER©

PART 1: INTRODUCTION TO THE MSB IN THE TEXTBOOK

CHOOSING THE BEST ENTRY STRATEGY

As firms pursue internationalization, managers must select the most suitable entry
strategy from among exporting, FDI, licensing, franchising, and the other strategies
described in this and previous chapters. Managers should carefully consider all the
costs and benefits—especially the possible expenses and revenues— involved with
each potential entry strategy. The ultimate objective of internationalization is usually to
maximize profits and market share. Failure to choose the best entry strategy can lead to
suboptimal performance.

Managerial Challenge
This C/K/R Management Skill Builder© examines the case of Gliders, a firm that makes
tennis shoes with an embedded wheel that allows the wearer to skate. Gliders is facing
growing competition from low-cost producers in countries such as China. In order to
confront this threat and increase sales, Gliders management wants to begin selling the
tennis shoes abroad and has targeted Germany as its initial market. Because Gliders is
a small firm with limited human and financial resources, management must choose the
best strategy to enter Germany in order to maximize company performance.

Background
Gliders’s target market is primarily children. Kids love to wear Gliders to dance, play
street hockey, and just glide around town. Preteens love them as alternative
transportation. The firm has an established brand name and is constantly retooling and
churning out upgraded wheel varieties, fashions, and comfort features. It also offers
various accessories, such as helmets and kneepads that feature the Gliders logo. The
firm owns other intellectual property, such as designs, trademarks, and patents.
Branding is extremely important, and management wants to maintain the shoes’ image
as quality and cool.
Managerial Skills You Will Gain
In this C/K/R Management Skill Builder©, as a prospective manager, you will:
1. Gain an understanding of the various types of foreign market entry strategies,
including the costs and benefits associated with each.
2. Learn how to improve a company’s prospects for increasing sales and profits in
foreign markets.
3. Develop an appreciation of an important component of international business
planning and strategy.

Your Task
Assume you are a recently hired, first-line manager at Gliders. Top management wants
to begin selling Gliders in Germany and has given you the task of conducting an
analysis to determine the most appropriate entry strategy, choosing among exporting,
licensing, FDI, and joint venture.

Go to the C/K/R Knowledge Portal©

www.prenhall.com/cavusgil
Proceed to the C/K/R Knowledge Portal© to obtain the expanded background
information, your task and methodology, suggested resources for this exercise, and
the presentation template.

PART 2: CONTINUATION OF THE MSB AT THE C/K/R KNOWLEDGE PORTAL©

CHOOSING THE BEST ENTRY STRATEGY

Expanded Background
Gliders is a small firm that makes tennis shoes with an embedded wheel that allows the
wearer to “skate.” The target market is children, who love Gliders to dance in, play
street-hockey in, and just glide around town. Gliders has an established brand name
and is constantly innovating, to produce upgraded wheel varieties, fashions, and
comfort features. Gliders also offers various accessories such as helmets and
kneepads, featuring the Gliders logo. Gliders owns other intellectual property, such as
designs, trademarks, and patents. Branding is extremely important, and management
wants to maintain the shoes’ image as quality and hip.

Gliders is only a few years old and generated US$56 million in sales last year. While the
company aims to increase domestic sales, it is beginning to face stiff competition from
abroad and wants to expand internationally. Management has heard stories of
companies in China and elsewhere copying its patented technology and launching their
own lines of Gliders-like shoes. Based on market research, Gliders management has
decided to target Europe, and wants its foreign launch to be in Germany.

As a manager at Gliders, you must identify the best strategy to enter Germany, from
among indirect exporting (via an export management company), direct exporting,
licensing, wholly-owned foreign direct investment, and joint venture. For simplicity,
assume that Gliders management will initially sell one style of skating shoe in Germany,
at a retail price of 100 euros. Management expects to add other shoes to its lineup over
time. By conducting market research and various inquiries in Germany, Gliders has
uncovered the alternative entry strategy options listed below. Management must choose
the single best entry strategy from among these.

Alternative 1: Indirect Exporting

Gliders identified an export management company – Total Exporting Solutions, Inc.
(TESI) – that can arrange to package, market, and ship Gliders shoes to import agents
in Germany. Given the indirect exporting strategy, no up-front investment in required.
TESI will simply pick up the shoes at Glider’s factory and ship them to its importers in
Germany. Like most export management companies, TESI lacks substantial
international marketing capabilities. Any marketing will be done by importing agents in
Germany. Glider’s only costs in the venture are a 40 percent fee to be paid to TESI.
That is, while the shoes’ retail price is 100 euros, TESI will purchase the shoes from
Gliders for 60 euros. Under this arrangement, Gliders management has little idea of
how its shoes will be managed or marketed in the target market. But TESI estimates it
can sell about 25,000 pair of shoes in Germany in the first year, rising by about 20
percent in each year thereafter.

Alternative 2: Direct Exporting

Gliders management identified an intermediary in Germany, Weber AG. Under this
option, Gliders would export the shoes directly to Weber, which has many connections
to shoe and sportswear retailers throughout Germany. Direct exporting requires
relatively little up-front investment except for some trips by Gliders managers to
Germany to meet with and provide some minimal training to Weber. For its part, Weber
requires a discount of 25 percent off the retail price of Glider’s shoes. In order words,
Gliders would sell its shoes to Weber for 75 euros. Because Weber is well connected in
the sports shoes market in Germany, Gliders can expect to penetrate deeply into the
market, particularly into major German cities. Weber also imports sports shoes and
skates from Nike, New Balance, and Sketchers, and handles some lines of the German
sports shoe giant, Adidas. Weber is largely unknown outside Germany and presently
lacks the resources to support substantial expansion into other European countries.
Weber will need financial support from Gliders to create marketing communications
tools such as brochures and advertising, and train its sales force to handle the
innovative Gliders shoes. Gliders management estimates it needs to send one
operational manager and one sales manager to Germany for a brief visit once a year,
paying their airfare, lodging, and food/entertainment expenses. Management plans to
devote about 2 percent of total annual sales revenue (on sales to Weber) to marketing
communications. Weber will provide warehousing for Gliders shoes in Germany as part
of the deal. Gliders management estimates it can sell about 40,000 pairs of shoes in
Germany each year and increase sales by about 25 percent in each year thereafter.

Alternative 3: Licensing
Gliders management met with another German firm – Braunschweig AG – that licenses
products in the German market. Braunschweig is interested in obtaining a license to
manufacture and sell the shoes under the Gliders brand name, with access to Gliders
other intellectual property, such as its shoe technology and marketing assets.
Braunschweig has offered various conditions. Although strongest in Germany,
Braunschweig management also wants to expand the proposed license to cover
Belgium, France, Italy, Spain, Switzerland, and the Netherlands. Braunschweig insists
on a 5-year exclusive agreement. In return, Gliders management calculated it would
require minimum sales performance of 75,000 pairs of shoes per year, with the option to
increase this minimum every year. Beyond this requirement, Braunschweig is free to
position and market Gliders shoes as appropriate for the German market. To seal the
licensing deal, Gliders is demanding an up-front lump-sum payment from Braunschweig
of 100,000 euros, plus a royalty of 7 percent on annual retail sales. In turn, Gliders must
share with Braunschweig its technology for making the shoes, as well as marketing
assets and other intellectual property. Braunschweig management indicated that it is
familiar with several shoe manufacturers in Eastern Germany and Poland. Gliders must
also provide training to Braunschweig’s sales personnel, and make annual visits to
Germany to inspect Braunschweig’s operations. Gliders management estimates it
needs to send one operational manager and one sales manager to Germany for brief
visits every year. Gliders is also expected to participate in cooperative marketing
programs with Braunschweig, the details of which would be decided later.

Alternative 4: Wholly-Owned Foreign Direct Investment

Gliders management met the owners of Kinski AG, a medium-sized manufacturer of
shoes near Berlin. Under this arrangement, Gliders would purchase Kinski’s shoe
factory. Management at Kinski is reputedly good, although the company's technology is
conventional. The factory was founded in the 1960s when Eastern Germany was part of
the Soviet Union. Gliders feels the Kinski plant can be converted to fit its needs. Kinski’s
owner – Werner Kinski -- wants to retire and is willing to sell his company for 22 million
euros. He stated that the German sports shoe market is booming and promises
profitable returns. The plant now serves the German market, but could be expanded to
sell to other European countries. Gliders management calculated the price Kinski
demanded was high, but Kinski countered that it is reasonable given the current
auspicious circumstances in Germany, and the rapid growth of Eastern European
markets. The benefit to Gliders, he argued, would be a significant market share and the
use of first-rate manufacturing facilities. However, Gliders management noted that a
similar plant could be constructed for less than 18 million euros. Kinski countered that
his plant is available immediately and would not require waiting for construction and
training of a new work force. Attempting to enter the market ‘from scratch’ by building a
plant against emerging competitors could be financially disadvantageous compared with
beginning immediately with a large market share. Table 1 below presents financial data
on this alternative.
TABLE 1
Estimated Income Statement for Coming Five Years for Gliders by Purchasing the Kinski plant

Current Current Current Current Current

Year Year + 1 Year + 2 Year + 3 Year + 4

Income Statement
Sales €22 €26 €32 €40 €50
Cost of Goods Sold 10 12 14 17 20
Selling and Administration Costs 3 3 4 4 5
Depreciation 2 3 4 5 5
Before Tax Income 7 8 10 14 20
Income Taxes 2 3 3 4 6
Net Income €5 5 7 10 14

Figures are in millions of euros

Alternative 5: Joint Venture

Werner Kinski understands the hesitation of Gliders management and thus, he offered
to enter into a joint venture whereby Gliders would acquire 51 percent of the Kinski
factory for 12 million euros. Gliders would also gain majority control of the Kinski board
of directors. Kinski would stay on as Chairman of the Board for three years to ensure a
smooth transition and the melding of the two companies and national cultures.
Naturally, in this alternative, Gliders ongoing expenses, revenues, and profits would be
about half of what they could obtain with full ownership. However, Glider’s risk would
also be commensurately lower.

Your Task and Methodology

Your task is to perform a systematic analysis to determine the best entry strategy for
Gliders to enter Germany from among the five alternative entry strategies presented
above. When deciding on entry strategies, firms typically conduct the analyses indicated
below. This C/K/R Management Skill Builder© has two parts. Your instructor may
have you complete MSB Part One, MSB Part Two, or both.

MSB Part One

Undertake a matrix-style analysis, as indicated in Table 2. Fill in the table by estimating
each of the following for each possible entry strategy: Amount of up-front investment
required; expected revenue from the venture; expected profits; amount of control that
Gliders can expect to maintain over its intellectual property and how its shoes are
marketed and managed in Germany; any type of commercial or other risk; and the
reversibility of the strategy (that is, the ease with which Gliders could withdraw from
Germany or change the type of entry strategy, in the event its initial entry was
unsuccessful).
TABLE 2
Comparison Matrix for the Five Alternative Entry Strategies
Criteria Amount of
up-front Expected Expected Expected
Investment revenue Costs profits Control Risk Reversibility
Strategies
Indirect
exporting, via
TESI

Direct
exporting, via
Weber

Licensing, via
Braunschweig

Wholly-owned
foreign direct
investment,
acquire Kinski
plant

Joint venture,
with Kinski

MSB Part Two

Perform a cost-benefit analysis on each possible entry strategy. Your goal is to identify
the entry strategy that has the highest value, as discounted for the time value of money.
Profit represents the net revenue earned over the life of each proposed entry strategy.
To ascertain the most profitable entry strategy, calculate the following for each of the
five entry strategies:

1. The total revenues and total costs that will result in each year over the life of the
alternative. Five years is a typical time horizon.
2. The net profit contribution for each year.
3. The cumulative profit contribution for each alternative entry strategy, discounted for
the time value of money (similar to a net present value analysis). That is, adjust the
estimated profit contributions to account for the time value of money, by using the firm’s
hurdle rate (required internal rate of return). That is, calculate the cumulative profit
contribution for each alternative entry strategy, discounted for the time value of money
(similar to a net present value analysis).

Use the following equation to complete your calculations:


(Rt - Ct )
(1 + i)t
t=0
where,
Rt = projected future revenue from the project during time period t;
Ct = projected initial and ongoing cost of the project during time period t (for example,
initial investment, as well as ongoing marketing costs, personnel costs, costs of
supporting foreign intermediaries, and so forth);
i = discount rate or firm’s required internal hurdle rate; and
t = period of time in years.
(Source: Root, Franklin, 1994, Entry Strategies for International Markets, New York, Lexington Books)

The best way to complete MSB Part Two is to use spreadsheet analysis. In cases
where key information appears to be missing (as is often the case in the “real world”),
you should estimate or assume the missing information.

Template
One way to complete MSB Part One is to estimate the actual amounts for the cells
indicated in the table below. As in actual situations in international business, this can be
challenging. Another approach is to provide more “qualitative” estimates for each of the
cells, as exemplified below. Next, write a report or a memo in which you justify the
estimates, labels, and recommendation that you have estimated.

Criteria Amount of
up-front Expected Expected Expected
Strategies Investment revenue Costs profits Control Risk Reversibility
Indirect None Low Low Low Low Low High
exporting, via
TESI
Et cetera
Direct
exporting, via
Weber

Licensing, via
Braunschweig

Wholly-owned
foreign direct
investment,
acquire Kinski
plant

Joint venture,
with Kinski
To complete MSB Part Two, construct a spreadsheet analysis for each alternative as
exemplified below, using the formula for net profit contribution given above. The
spreadsheet for Alternative 1 is completed as an example.

In completing this exercise, you may feel that some information is missing from the
explanations for the five different alternatives given above, and this limits your ability to
make accurate estimates to complete the exercise. However, note this is typical of
actual conditions in the real world of international business in which managers generally
make decisions without having complete information.
 Alternative 1: Indirect Exporting
End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 1,500,000 1,800,000 2,160,000 2,592,000 3,110,400 11,162,400
Cost 0 0 0 0 0 0 0
Net Profit Contribution 0 1,500,000 1,800,000 2,160,000 2,592,000 3,110,400 11,162,400
(Revenue – Cost)
Net Profit Contribution / 0 1,363,636 1,636,364 1,963,636 2,356,364 2,827,636 10,147,636
(1 + i)
Note 1: For example, Revenue in Year 1 is calculated as 25,000 pairs of shoes times 60 euros, rising by 20% each year
Note 2: We assumed the firm’s hurdle rate (i) is 10%

Alternative 2: Direct Exporting

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue
Cost
Net Profit Contribution
(Revenue – Cost)
Net Profit Contribution /
(1 + i)
Alternative 3: Licensing
End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue
Cost
Net Profit Contribution
(Revenue – Cost)
Net Profit Contribution /
(1 + i)

Alternative 4: Wholly-Owned Foreign Direct Investment

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue
Cost
Net Profit Contribution
(Revenue – Cost)
Net Profit Contribution /
(1 + i)

Alternative 5: Joint Venture

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue
Cost
Net Profit Contribution
(Revenue – Cost)
Net Profit Contribution /
(1 + i)
PART 3: INSTRUCTOR’S MATERIAL AT THE C/K/R KNOWLEDGE PORTAL©
CHOOSING THE BEST ENTRY STRATEGY

Note to Instructor: In teaching this MSB, it is useful to show the website for Heelys
company (www.heelys.com), upon which this exercise is based.

Typical Solution for MSB Part One

After reviewing the different entry modes to expand business into Germany, the student
should estimate various factors to decide which strategy is best for Gliders. Initially,
examine the amount of up-front investment required. Indirect exporting requires none
and direct exporting requires very little. Only a few trips to Germany by Gliders
management to meet with and provide some minimal training to Weber would be
needed. Licensing requires slightly more up-front investment. Gliders must provide
training to personnel in Germany and make annual visits to Germany to inspect
operations. Also, Gliders must participate in cooperative marketing in addition to giving
Braunschweig its technology for making shoes as well as marketing assets and other
intellectual property. In contrast to these strategies, wholly-owned foreign direct
investment requires a very large amount of up-front investment. The costs are 22 million
euros to acquire an existing plant in Germany, and 12 million euros to enter a 51-49
joint venture.
Expected revenue differs among the different entry mode options. Indirect
exporting would produce low revenue with first years total at 1,800,000 euros and
increasing at a rate of 20% each year after. Direct exporting would be relatively high
when compared with the other entry modes at 3,750,000 increasing at a rate of 25%.
Licensing revenue for the first year is also relatively low. Expected revenue for wholly-
owned FDI has the most revenue the first year at 5,000,000 euros and will continue to
increase in the coming years. Joint venture produces medium revenue but not as much
as direct exporting or wholly-owned FDI.
Expected costs among the different entry strategies run the range from virtually
zero to very high. Indirect exporting, direct exporting, and licensing incur no costs.
Wholly-owned FDI incurs costs of 22,000,000 euros to acquire the plant and joint
venture requires a payment of 12,000,000 euros for a 51-49 stake in the same plant.
Expected profits among the entry strategies differ mainly with respect to wholly-
owned FDI and joint venture strategies. Indirect exporting, direct exporting, and
licensing have relatively low profits but will increase over the coming years. Wholly-
owned FDI has no profits in the first year and instead incurs a 17,000,000 euro loss due
to revenue of 5,000,000 less costs of 22,000,000. It is not until the 4th year that Gliders
will see a profit of 5,000,000 euros. After the 5th year of expected profits of 14,000,000
the company should continue to see healthy growth. The joint venture option will also
see negative initial profits. The first year will report earnings of negative 9,500,000 euros
due to profits of 2,500,000 euros and costs of 12,000,000 euros. But like wholly-owned
FDI, the company will see positive earnings in the 4th year of 1,500,000 euros. With
earnings of 5,000,000 euros the company will emerge from its negative earnings and
being seeing real profits which are also expected to continue increasing.
 Management must balance risk versus return. Management must also decide
how much control it wants to maintain over the venture. Risk and control are somewhat
correlated: As risk rises, so does the amount of control. Starting with indirect exporting
at the lowest degree of control and the lowest amount of risk is then followed by direct
exporting, licensing, joint venture and eventually wholly-owned FDI which has the
highest degree of control and the highest amount of risk. Reversibility for the different
entry strategies falls in line with the rest of the data. Indirect exporting has high
reversibility which means that Gliders can easily withdraw from Germany or change the
type of entry strategy. Direct exporting is also easily reversed. Licensing is much less
reversible because the Braunschweig contract is for five years. This means that Gliders
is obligated and cannot back out of the contract. Wholly-owned FDI has a very low rate
of reversibility because once you’ve acquired the plant its permanent. Until you can sell
the plant, Gliders will be locked in. Joint venture also has low reversibility because once
again Gliders is largely locked in.
Under ideal conditions (which is generally not the case), Gliders should opt for
wholly-owned FDI strategy and acquire the plant from Kinski for 22,000,000 euros. The
first three years will show negative profits but starting with the fourth year the company
will be making very respectable money. Even though this option entails the greatest
risk, the highest cost, and locks Gliders into a permanent commitment, if managed well,
the firm can benefit most from this option. This option produces the most revenue and
profit and gives the company complete control of its assets, both tangible and
intangible. Using FDI, Gliders will be best positioned to develop and maintain a strong
brand name and image, which are prerequisites for future European expansion. Gliders
faces growing competition and needs to strongly implant itself in Europe, which is
undoubtedly its best major market outside the United States. Firming getting established
in Germany provides the means to expand the business into other key European
markets.
 Criteria Amount of
up-front Expected Expected Expected
Investment revenue Costs profits Control Risk Reversibility
Strategies
Indirect none low low low low low high
exporting, via
TESI
little medium Low High low low High
Direct
exporting, via
Weber

Medium Medium Medium Low Low/med- medium low

Licensing, via um
Braunschweig

Wholly-owned Very high High Very high High Very high- Very high Very low
foreign direct complete
investment, control
acquire Kinski
plant

Joint venture, high High high high 51/49 High Low

with Kinski
Typical Solution for MSB Part Two
Alternative 1: Indirect Exporting
End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 1,500,000 1,800,000 2,160,000 2,592,000 3,110,400 11,162,400
Cost 0 0 0 0 0 0 0
Net Profit Contribution 0 1,500,000 1,800,000 2,160,000 2,592,000 3,110,400 11,162,400
(Revenue – Cost)
Net Profit Contribution / 0 1,363,636 1,636,364 1,963,636 2,356,364 2,827,636 10,147,636
(1 + i)

Note 1: For example, Revenue in Year 1 is calculated as 25,000 pairs of shoes times 60 euros, rising by 20% each year
Note 2: We assumed the firm’s hurdle rate (i) is 10%

Alternative 2: Direct Exporting

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 3,000,000 3,750,000 4,687,000 5,859,375 7,324,594 24,620,969
Cost 0 60,000 75,000 93,740 117,188 492,412 838,340
Net Profit Contribution 0 2,940,000 3,675,000 4,593,260 6,742,187 6,832,182 23,782,629
(Revenue – Cost)
Net Profit Contribution / 0 2,672,727 3,340,909 4,175,691 5,220,170 6,211,075 21,620,571
(1 + i)

Note: All alternatives are based on i=10%

 Alternative 3: Licensing
End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 625,000 656,250 820,313 1,025,391 1,281,738 4,408,692
Cost 0 0 0 0 0 0 0
Net Profit Contribution 0 625,000 656,250 820,313 1,025,391 1,281,738 4,408,692
(Revenue – Cost)
Net Profit Contribution / 0 568,182 596,591 745,739 932,174 1,165,216 4,007,902
(1 + i)

Note: Assume that Gliders are sold for 100 euros and that sales increase at a rate of 25% per year

Alternative 4: Wholly-Owned Foreign Direct Investment

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 5,000,000 5,000,000 7,000,000 10,000,000 14,000,000 41,000,000
Cost 0 22,000,000 17,000,000 12,000,000 5,000,000 0 22,000,000
Net Profit Contribution 0 -17,000,000 -12,000,000 -5,000,000 5,000,000 14,000,000 19,000,000
(Revenue – Cost)
Net Profit Contribution / 0 -15,454,545 -10,909091 -4,545,455 4,545,455 12,727,273 17,272,727
(1 + i)

Alternative 5: Joint Venture

End of Time Period t
Estimates (in euros) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative
Revenue 0 2,500,000 2,500,000 3,500,000 5,000,000 7,000,000 20,500,000
Cost 0 12,000,000 9,500,000 7,000,000 3,500,000 0 12,000,000
Net Profit Contribution 0 -9,500,000 -7,000,000 -3,500,000 1,500,000 7,000,000 8,500,000
(Revenue – Cost)
Net Profit Contribution / 0 -8,636,364 -6,363,636 -3,181,818 1,363,636 6,363,636 7,727,273
(1 + i)
VII. TEACHING NOTES

Please refer to the C/K/R Knowledge Portal© for additional exercises,

teaching aids, cases, videos, readings, and other material:
www.prenhall.com/cavusgil

ADDITIONAL SOURCES:

https://ostiweb.osti.gov/iaem/
http://www.entrepreneur.com/franzone/listings/topglobal/