CHAPTER 1: INTRODUCTION
1
CHAPTER 1
INTRODUCTION
1. Explain how globalization may affect even a small business in your local area.
A small business in any local area now faces competition from both large MNCs and similarly situated
businesses that take advantage of their international experience as well as internationally sourced
products.
2. Opponents of globalization and outsourcing argue that locating manufacturing activities
abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather than
resulting in a net loss of jobs, employment has actually increased. Also, the average wages of
workers have increased. How would you account for this discrepancy between what the critics
say and what statistics reveal?
ANSWER. Globalization is a two-way street. While some U.S. firms locate their plants overseas, several
foreign companies have also invested in the U.S. economy and located their plants here. For example,
major foreign automobile manufacturers such as Toyota and BMW have set up manufacturing plants in
the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the U.S. economy has experienced
unprecedented productivity growth due to the increase in trade from globalization. The net impact of this
productivity growth as measured in output per hour has been such as to increase the inflation-adjusted
worker compensation. Thus, while critics of globalization look at only one side of the picture and point to
job losses due to outsourcing, they neglect to take into account the job creation due to foreign investment
in the U.S. and the increase in trade due to globalization. Critics also ignore the fact the increased
opportunities for trade due to globalization result in high-value-added services being performed in the
U.S. and the increase in productivity of the U.S. worker. As a result, worker wages have also gone up.
4. What are the various reasons for the emergence of multinational firms?
SEARCH FOR RAW MATERIALS.
Some firms become MNCs to exploit the raw materials that can be found
overseas, such as oil, coal, minerals, and other natural resources.
MARKET SEEKING.
Some firms become MNCs to exploit foreign markets for their products. Since the
same product may be demanded in different countries, MNCs not only take advantage of the
marketing opportunities, but also gain from the economies of scale obtained by selling large volumes
across different foreign markets.
COST MINIMIZATION.
Companies also become MNCs to seek out lower-production-cost sites. Specific
skills needed for production may be available at lower costs in some countries, and MNCs may locate
plants specializing in specific aspects of production, such as assembly or fabrication, in those
countries.
KNOWLEDGE SEEKING.
Some firms enter foreign markets to gain information and experience that are
expected to prove useful elsewhere. Especially in industries characterized by rapid product innovation
and technical breakthroughs, firms obtain technical product and process knowledge, which they
leverage in other countries.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
KEEPING DOMESTIC CUSTOMERS.
Suppliers of goods or services to MNCs often follow their customers
abroad to guarantee them a continuing product flow. In the process, these firms also become MNCs.
EXPLOITING FINANCIAL MARKET IMPERFECTIONS.
Companies may find it advantageous to reduce taxes and
circumvent currency controls when operating in multiple foreign markets. Doing so enables them to
obtain greater project cash flows and lower costs of funds compared to a purely domestic firm.
5. Given the added political and economic risks that appear to exist overseas, are MNCs more or
less risky than purely domestic firms in the same industry? Consider whether a firm that
decides not to operate abroad is insulated from the effects of economic events that occur outside
the home country.
Individual foreign projects may face more political and economic risks than comparable domestic
projects. Yet MNCs are likely to be less risky than purely domestic firms because much of the risk faced
overseas is diversifiable. Moreover, by operating and producing overseas, the MNC has diversified its
cost and revenue structure relative to what it would be if it were a purely domestic firm producing and
selling in the home market. It is important to note that domestic firms are not insulated from economic
changes abroad. For example, domestic firms face exchange risk because their competitive positions
depend on the cost structures of both foreign and domestic competitors. Similarly, changes in the price of
oil and other materials abroad immediately lead to changes in domestic prices.
8. What are the various ways in which domestic firms enter international markets? What are the
benefits and risks of each strategy of foreign market entry?
Entry
Exporting
Benefits
 Minimal capital requirements and start-up
costs
 Relatively low risk compared to other entry
strategies
 Risk is low
 Full sales potential of the product is not
realized
 Profits are immediate
Licensing
Risks
 Learn about present and future supply and
demand, competition, distribution channels,
payment conventions, financial institutions,
and financial techniques in host country
 Foreign importer is in greater control of
marketing, and thus the image, of the firm’s
branded products in the foreign country
 Minimal investment requirements
 Cash flow is relatively low
 Faster market-entry time
 May be problems in maintaining product
quality standards
 Fewer financial and legal risks
 Foreign licensee may engage in unauthorized
exports of the firm’s products, resulting in
loss of future revenues for the licensing firm
 Foreign licensee may become a strong
competitor when license agreement ends
Overseas
Production
 The firm can more easily stay abreast of
market developments, adapt its products and
production schedules to changing local tastes
and conditions, fill orders faster, and provide
more comprehensive after-sales service
 Firm can exploit local skills, including R&D
 Signals a greater commitment to the local
 Tremendous capital and top management
commitment is required
 Financial and operational risks are greater
than those for other entry strategies
 Companies face greater political risks,
including the risk of expropriation of plants
and facilities
CHAPTER 1: INTRODUCTION
3
market, which in turn increases sales and
assurance of supply stability
10. What factors help determine whether a firm will export its output, license foreign companies
to manufacture its products, or set up its own production or service facilities abroad? Identify
the competitive advantages that lead companies to prefer one mode of international expansion
over another.
i)
PRODUCTION ECONOMIES OF SCALE.
If these are important, then exporting might be appropriate.
ii) TRADE BARRIERS. Companies that might otherwise export to a market may be forced by regulations to
produce abroad, either in a wholly owned operation, a joint venture, or through a licensing
arrangement with a local manufacturer.
iii) TRANSPORTATION COSTS. These have the same effect as trade barriers. The more expensive it is to ship
a product to a market, the more likely it is that local production will take place.
iv) SIZE OF THE FOREIGN MARKET. The larger the local market, the more likely local production will take
place, particularly if significant production economies of scale exist. Conversely, with smaller
markets, exporting is more likely to take place.
v) PRODUCTION COSTS. The real exchange rate, wage rates, and other cost factors will also play a part in
determining whether exporting or local production takes place.
vi) INTANGIBLE CAPITAL. If the MNC’s intangible capital is embodied in the form of products, exporting
will generally be preferred. If intangible capital takes the form of specific product or process
technologies that can be written down and transmitted objectively, foreign expansion will usually take
the licensing route. If intangible capital takes the form of organizational skills that are inseparable
from the firm itself, then the firm is likely to expand overseas via direct investment.
vii) NECESSITY OF A FOREIGN MARKET PRESENCE. By investing in fixed assets abroad, companies can
demonstrate to local customers their commitment to the market. This can enhance sales prospects.
1.a. What are the various categories of MNCs?
Raw materials seekers, market seekers, and cost minimizers.
8.a. Are MNCs riskier than purely domestic firms?
Although MNCs are confronted with many added risks when venturing overseas, they can also take
advantage of international diversification to reduce their overall riskiness. We will also see in Chapter 16
that foreign operations enable MNCs to retaliate against foreign competitive intrusions in the domestic
market and to more closely track their foreign competitors, reducing the risk of being blindsided by new
developments overseas.
9. Is there any reason to believe that MNCs may be less risky than purely domestic firms?
Explain.
ANSWER. Yes. International diversification may actually enable firms to reduce their total risk. Much of
the general market risk facing a company is related to the cyclical nature of the domestic economy of the
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
home country. Operating in a number of nations whose economic cycles are not perfectly in phase may,
therefore, reduce the overall variability of the firm’s earnings. Thus, although the riskiness of operating in
any one country may exceed the risk of operating in the U.S. (or other home country), much of that risk is
eliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears to
decline as firms become more internationally oriented.
SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS
3. Given the resources available to them, countries A and B can produce the following
combinations of steel and corn.
Country A
Country B
Steel (tons)
Corn (bushels)
Steel (tons)
Corn (bushels)
36
0
54
0
30
3
45
9
24
6
36
18
18
9
27
27
15
12
18
36
6
15
9
45
0
18
0
54
3.a. Do you expect trade to take place between countries A and B? Why?
ANSWER. Yes. Given the data presented, if country A has 6 units of resources and it devotes X of these
units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X)
bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel
production, it can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production
functions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is
worth only one ton of steel in country B. These relative prices indicate that country A has a comparative
advantage in the production of steel, whereas B has a comparative advantage in the production of corn.
3.b. Which country will export steel? Which will export corn? Explain.
ANSWER. Given these comparative advantages, A will export steel and B will export corn. The price of
corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then,
instead of producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit
to the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4
bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4
bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources it
took to produce the 4 bushels of corn.