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Evaluating Markets to Invest global
E. N. Roussakis and Anastasios Moysidis Abstract: This case deals with the key considerations when planning an international expansion through direct investment in foreign markets. These considerations must be addressed by a finance company seeking to establish foreign subsidiaries to support the international sales of its parent firm, a U.S.-based multinational enterprise (MNE). The company already operates three foreign subsidiaries–in Canada, Mexico (both NAFTA members), and the United Kingdom–but wishes to increase this network further through entry into additional markets. Ten candidate countries are being considered to determine the five most suitable for entry. Hence the need for a rational decision of where to invest.
Keywords: Subsidiaries; multinational enterprise; transnational activities; foreign direct investment; g r e e n f i e l d i n v e s t m e n t ; l e v e r a g e d i n s t i t u t i o n ; w h o l e s a l e f i n a n c i n g ; c a p t i v e finance company; retail installment contract
1 Introduction
Victoria Pernarella is a recent university graduate in business administration and a new hire in Bertos Financial Services, Inc., a major finance company in Nashville, Tennessee. After a month long rotational t r a i n i n g to gain ins igh ts in to the company’s scope o f activities, she was placed in the international department where she has been assigned to work on a project. Bill Pappas, her manager, had asked her to analyze a select number of foreign countries to determine the best prospects for the local establishment of subsidiary finance companies. He went on to clarify that the mode of entry into the foreign markets– acquisition of an existing company or a greenfield investment (from the ground up, that is, from a green field)–was not a primary consideration at this stage. The candidate countries were Jamaica, Iceland, Morocco, Vietnam, Georgia, Senegal, Paraguay, Oman,
Albania and El Salvador. With finance companies highly leveraged institutions, the firm was prepared to provide the initial amount of equity capital needed for the establishment of five such institutions. At this stage therefore, the study ought to limit its recommendation to a corresponding number of foreign countries.
With this information at hand, Victoria started reflecting on the approach to use for her analysis. Sensing the need to prove her capabilities by delivering a high quality study for her first company assignment, she thought appropriate to first familiarize herself with the pertinent literature on the international expansion of multinational enterprises (MNE) in general a n d b a n k s in particular, a n d then rev iew b a c k g r o u n d i n f o r m a t i o n o n he r employer, and the scope of activities of its financial subsidiary. Hence the sequence of the following sections which address the internationalization process (literature review on the development o f MNEs), the modes of bank entry into foreign markets, background of parent company, financial subsidiary and scope of activities, and developing criteria for country recommendation.
2 Internationalization Process–A Theoretical Perspective Recent decades have witnessed the internationalization of operations of many companies around the world, and especially U.S. corporations. Although the extent, form and pattern of their transnational a c t i v i t i e s v a r y according t o the characteristics o f the firms, the products t h e y p r o d u c e , a n d t h e m arke t s i n which t h e y o p e r a t e , t h e y a l l ref lect t h e dynamics of a changing and increasingly competitive international environment. Of the theories that have sought to explain the transnational activities of enterprises, the eclectic paradigm (Dunning, 1988) enjoys a dominant position. This concept provides a broad framework for the alternate channels of international economic involvement of enterprises and focuses on the parameters that influence individual MNE foreign investment decisions (Buckley and Casson, 1976; Dunning, 1977). Specifically, the eclectic paradigm identifies three important determinants in the transnational activities of firms– ownership, location and internalization (OLI). The first condition of the OLI configuration states that a firm must possess certain owner-specific competitive advantage in its home market that can be transferred abroad if the firm’s foreign direct investment (FDI) is to be successful. This advantage must be firm specific, not easily copied, transferable, and powerful enough to compensate the firm for the potential disadvantages and risks of operating abroad. Certain ownership-specific competitive advantages enjoyed in the home market, such as financial strength and economies of scale, are not necessarily firm specific because they can be also attained by other f i rms. Similarly, c e r t a i n types of technology d o not ensure a firm – specific advantage because they can be purchased, licensed or copied. Production and marketing o f differentiated p roduc t s , too, can lose their competitive e d g e to modified versions of such products promoted by lower pricing and aggressive marketing.
The second strand in the OLI model stands for location-specific advantages. That Is, the foreign market m us t possess cer ta in characteristics t h a t will allow the firm to exploit its competitive advantages in that market. Choice of location may be a function of market imperfections or of genuine comparative advantages of particular places. Other important considerations that may influence the locational decision may include a low- cost but productive labor force, unique sources of raw materials, formation of a custom unions or regional trading bloc, defensive investments to counter a firm’s competitors, or centers of advanced technology.
The third component of the OLI paradigm is internalization and refers to the importance for a firm to safeguard its competitive position by maintaining control of its entire v a l u e c h a i n in its industry. This c a n b e accomplished through f o r e i g n d i r e c t investment r a t h e r t h a n l icens ing o r outsourcing. Transferring p r o p r i e t a r y i n f o r m a t i o n across national boundaries within its own organization would enable a firm to maintain control of its firm-specific competitive advantage. Establishment of wholly owned subsidiaries abroad r e d u c e s t h e f i n a n c i a l agency c o s t s t h a t a r i s e f r o m a s y m m e t r i c information, lack of trust and the need to monitor foreign partners, vendors, and financial intermediaries. Further, if the parent firm funds the operations of its foreign subsidiaries, self-financing el iminates the need to observe specific debt provisions that would result from local financing. If a multinational firm has access to lower global cost and greater availability of capital why subject its operations to local financial norms or share these important advantages with local joint venture partners, distributors, licensees, and banks that would probably have a higher cost of capital.
Of t h e t h r e e p r e m i s e s o f t h e p a r a d i g m described a b o v e , t h e s e c o n d s t r a n d (locational a d v a n t a g e ) h a s been the subject o f increased t r e a t i s e . Although i n theory market imperfections and comparative advantage are key considerations in determining the attractiveness of particular locations, in practice firms have been observed to follow a search pattern influenced by behavioral factors. As rational decisions require availability of information and f a c t s , d e t e r m i n i n g where t o i n v e s t a b r o a d f o r t h e f i r s t t i m e i s significantly more challenging than where to reinvest abroad. The implication is that a firm learns from its operations abroad and what it learns influences subsequent decisions. This premise lies behind two related behaviora l t h e o r i e s o f foreign direct investment decisions–the behavioral approach and international network theory. The former, exemplified b y the Swedish S c h o o l o f economists (Johansen a n d Wiedersheim-Paul, 1975; Johansen a n d Valhne, 1 9 7 7 ), sough t to explain b o t h the initial a n d la ter F D I decisions of a sample of Swedish MNEs based on these firms‟ scope of international operations over time. The study identified that these firms favored initially countries in “close psychic distance”; that is, they tended to invest first in countries that possessed a similar cultural, legal, and institutional environment to that of Sweden’s, e.g., in such countries as Denmark, Finland, Norway, Germany and the United Kingdom. As the firms gained knowledge and experience f r o m their initial opera t ions, they tended to accept greater r i s k s bo th in terms of the countries’ psychic d i s t a n c e a n d t h e s i ze o f their investments.
The development and growth of Swedish companies over time, contributed to a transformation i n the nature of the parent/foreign-subsidiary relationship. The international network theory addresses this transformation by identifying such changes as the evolution of control from centralized to decentralized, nominal authority of the parent firm over the organizational network, foreign subsidiaries competing with each other and with the parent for resource allocations, and political coalitions with competing internal and external networks.
Some authors (Eiteman et al., 2010) view the internationalization of operations as an outgrowth o f sequential s t a g e s in the development o f a f irm. They re fe r t o this progression in the scope of business activity as the globalization process and identify three distinct phases. In the domestic phase, a company sells its products to local customers, and purchases i t s manufacturing a n d service inputs f r o m local vendors . As the company grows to become a visible a n d viable c o m p e t i t o r a t home, i m p e r f e c t i o n s i n foreign national markets or comparative advantages of particular locations translate into market opportunities and provide the impetus for an expansion strategy. Entry into one or more foreign markets will make the company attain the international trade phase. At this stage the company i m p o r t s i t s inputs f rom f o r e i g n s u p p l i e r s a n d e x p o r t s i t s products a n d services to foreign buyers. In this facet, the firm faces increased challenges of its financial management, o v e r and above the traditional requirements o f the domestic-only p h a s e . Exports and imports expose the firm to foreign exchange risk as a result of currency fluctuations in global markets. Moreover, they expose the firm to credit risk management; assessing the credit quality of the foreign buyers and sellers is more formidable than in domestic business. When the firm senses the need to set up foreign sales and service affiliates, manufacture abroad or license foreign firms to produce and service its products, it progresses to the third phase, the multinational phase. Many multinational enterprises prefer t o invest i n w h o l l y o w n e d s u b s i d i a r i e s t o main ta in e f f e c t i v e c o n t r o l o f their competitive
advantage and any new information generated through research. Ownership of assets and enterprises in foreign countries exposes the firm’s FDI to political risk– political events that can undermine the economic viability and performance of the firm in those countries. Political r i s k can range from seizure of property (expropriation) a n d ethnic strife to conflict with the objectives of the host government (governance risk) and limitations on the ability to transfer funds out of the host country (blocked funds).
Figure 1 portrays the sequential s t a g e s in a firm’s international e x p a n s i o n and provides an overview of the globalization process and the FDI decision. For a firm with a competitive advantage in i t s h o m e m a r k e t , a t y p i c a l sequence in i t s i n t e r n a t i o n a l expansion would be the reach to one or more foreign markets by first using export agents and other intermediaries before engaging in direct dealings with foreign agents and distributors. As the firm learns more about foreign market conditions, payment conventions and financial institutions it feels more confident in establishing its own sales subsidiary, service facilities and distribution system. These moves culminate in foreign direct investments and control of assets abroad. Some of these assets may have been built from the ground up, or acquired through purchase of an existing firm or facility. As the level of physical presence in foreign markets increases so does the size of foreign direct investment.
3 Modes of Bank Entry into Foreign Markets
Unlike industrial and manufacturing firms, w h i c h have expanded internationally along the patterns suggested above (eclectic paradigm and globalization process), financial institutions h a v e entered fo re ign marke ts p r imar i ly i n response to the needs of their business clients. Indeed, this has been the case for commercial banks, the oldest and most dominant institution of the U.S. financial system. The growth of multinational corporations and the accelerating pace of globalization in business activity increased the demand for international financial services and i n d u c e d the e x p a n s i o n of b a n k s ’ international operations a n d p r e s e n c e a b r o a d . Whether p r o a c t i v e l y (to e n h a n c e o w n growth and profitability) or defensively (to deny a competitor the benefit of the client’s business), banks have sought to enter foreign markets early and quickly to gain from the first-mover advantage. The rush of Western banks into Central and Eastern Europe in the 1990s exemplifies the drive to gain this first-mover advantage (Hughes and MacDonald, 2004).
In weighing entry into a foreign market a number of factors must be taken into account, including the bank’s resources (both financial and human), projected volume of international business, k n o w l e d g e o f –and e x p e r i e n c e w i t h –foreign markets, b a n k i n g structure a n d r e g u l a t i o n i n the c o u n t r i e s t a r g e t e d f o r e n t r y , t a x c o n s i d e r a t i o n s , and customer profile. A key variable in the decision process is the vehicle to be used in the delivery of international services. Major banks around the world have used anyone or a combination of vehicles to structure their international o p e r a t i o n s . The lowest possible level of presence in a foreign market may be attained through a correspondent banking relationship–using a native institution to provide the financial services needed in that market. This approach may be duplicated in one or more countries abroad, as needed, for the p r o c e s s i n g o f i n t e r n a t i o n a l transactions. It e n t a i l s n o i n v e s t m e n t and h e n c e n o
Exposure to the foreign market. Extension o f services may be based on a reciprocal deposit account between the banks or an individual fee per transaction. A representative office e n a b l e s a physical p r e s e n c e i n a f o r e ig n m a r k e t . However, i t canno t p r o v i d e traditional banking services; it can only engage in such activities as serving as a liaison and performing marketing function for the parent bank. As it does not constitute a legal entity it has no legal or tax liability. An agency may perform more functions than a representative office but cannot perform all banking functions (e.g., in the United States a foreign b a n k a g e n c y m a y ex tend l o c a l l o an s b u t cannot a c c e p t l o c a l d e p o s i t s ). The principal vehicle used by U.S. banks in the conduct of their activities internationally is the branch office. This office is a legal and operational part of the parent bank, backed the full resources of the parent in the performance of the banking functions permitted by the host country. Although it requires a sizable investment it enables the provision of full banking services, which t h e prior v e h i c l e s d o not. A branch o f f i c e is subject t o two sets of regulation–those o f the home country and those of the host country. A subsidiary is a separate legal entity organized under the laws, and hence regulated by the authorities, of the host country. It is the second most important vehicle used by commercial banks for the conduct of banking business, and may be established as a new organization or through the purchase of an existing institution. Whatever the approach used in its establishment, a subsidiary offers two important advantages over a branch: it may provide for a wider range of services, and it limits the liability of the parent bank to the amount of its equity investment i n that en t i ty . The main d i sadvan tage o f a subsidiary i s that it must be separately capitalized from the parent bank, which may often entail a greater start up investment than a branch (Rose and Hudgins, 2010).
U.S. finance companies interested to expand their activities internationally take into account many of the same criteria used by banks. In structuring their international operations U.S. finance companies favor the subsidiary organizational form because of the advantages associated with this type of vehicle. Just as in U.S. financial markets, foreign financial s u b s i d i a r i e s a r e heavy users of debt in financing t h e i r operations. Principal sources of borrowed funds include bank credits and issues of debt (e.g., bonds) in capital markets to finance their lending activities in their respective m a r k e t s (Madura, 2011; Gitman et al., 2010). Finance companies are extremely diversified in their credit granting activities, offering a wide range of loans, leasing plans and long term credit to support capital investment. One of the most important markets for finance companies has been the extension of business-oriented financial services including working capital loans, revolving credit and equipment lease financing.
4 Background of Parent Company
Bertos Manufacturing Corporation (BMC) is one of the largest companies of the country in the manufacturing of construction and mining equipment, and engines. BMC draws its origin in a California firm organized in 1890 to manufacture steam-powered tractors for farming. The firm was nominally capitalized and aspired to make inroads in the local market by having its tractors plow California fields. However, soon after the turn of the century, a n abandoned m a n u f a c t u r i n g p l a n t b y a f a i l e d t r a c to r c o m p a n y i n a m a j o r manufacturing c e n t e r in Illinois was instrumental in the relocation of operations in the
Midwest. The l o c a t i o n of t h i s c e n t e r on t h e Mississippi River made i t a prime transportation hub offering important prospects for the young company. Indeed, the move proved a turning point in the development of the company. Domestic sales grew so significantly that by 1911 the factory employed a little over 600 individuals. A natural consequence o f the dom es t i c m o m e n t u m w a s t h e f i r m ’ s entry i n t o f o r e i g n m a r k e t s through tractor exports to Argentina, Mexico, and Canada.
World War II was a company miles tone as it created a sharp increase in the demand for tractors to built airfields and other military facilities in strategic sites of the Pacific. However, it was during
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