Problem Set 3
International Finance
Fall 2006
Shrikhande
A. MNC Capital Budgeting - Qualitative
1.
Early results on the Lexus, Toyota's upscale car, showed it was taking the most business from customers
changing from either BMW (15%), Mercedes (14%), Toyota (14%), General Motors' Cadillac (12%), and
Ford's Lincoln (6%). With what in the auto business is considered a high percentage of sales coming from its
own customers, how badly is Toyota hurting itself with the Lexus?
ANSWER. Toyota appears to be hurting itself with Lexus. But, in fact, Lexus is doing exactly what Toyota
intended: retaining customers, since Toyota determined that many of its customers who switched to Lexus were
ready to "trade up" to a luxury car. Now Toyota's customers are trading up to a Lexus instead of a BMW or
Mercedes. The key point is that the cannibalization is more apparent than real: If Toyota had not built the Lexus, it
would have lost these customers anyway, but to another company.
2.
Comment on the following statement that appeared in The Economist (August 20, 1988, p. 60): Those oil
producers that have snapped up overseas refineries--Kuwait, Venezuela, Libya and, most recently, Saudi
Arabia--can feed the flabbiest of them with dollar-a-barrel crude and make a profit.... The majority of OPEC's
existing overseas refineries would be scrapped without its own cheap oil to feed them. Both Western European
refineries fed by Libyan oil (in West Germany and Italy) and Kuwait's two overseas refineries (in Holland and
Denmark) would almost certainly be idle without it.
ANSWER. The statement that OPEC can make a profit from these refineries is incorrect, assuming the author is
referring to true economic profit. On an integrated basis, profits on the refinery are more than offset by losses on
sales of the crude oil at subsidized prices. In fact, the oil producers are cross-subsidizing their refineries. They
would be better off without the refineries and selling their oil on the open market. As noted in the chapter,
investments should be evaluated taking into account the true opportunity costs of all the assets used.
3.
Some economists have stated that too many companies are not calculating the cost of not investing in new
technology, world-class manufacturing facilities, or market position overseas. What are some of these costs?
How do these costs relate to the notion of growth options discussed in the chapter?
ANSWER. The company that gets to market first often goes on to dominate it. Those companies that don't invest
early may quickly be out of the business altogether. They may also lose out on other opportunities that were not
foreseen at the time of the investment decision, but that developed later. For example, a company that forgoes
investment in a novel technology passes up the chance to explore its technical possibilities, market opportunities,
development costs, and competitors' strategies. In other words, initial expenditures on product and process
technologies and market position should be viewed as investments in information and in the creation of options to
utilize that information in ways that may not have been envisioned originally. For example, Merck, the
pharmaceutical firm, decided to invest in an automated packaging and distribution plan, even though the labor
savings didn't justify the investment, in order to explore the potential benefits of plant automation. Results from the
pilot project have clarified these benefits to the point that Merck is now expanding automation to its diverse
manufacturing operations. Thus, firms that forgo investments in are passing up the chance to create and act on
options. And the fact that a company passes up the chance to invest in options does not mean that its competitors
will. For example, an auto maker may give up on ceramic engines, because technically they seem infeasible. But a
rival who makes prosaic ceramic parts with the aim of one day using the knowledge to build a ceramic engine--as
the Japanese are doing--can quickly change the competitive balance. Similarly, although liquid crystal displays
(LCDs) are a U.S. invention (they were developed by RCA, which abandoned them as uneconomic), Japanese
companies used them to make watches and small TVs; now they lead in LCD flat-panel computer screens. The
ability to make these displays are a major reason Toshiba and other Japanese firms have won a large share of the
laptop computer market. Moreover, the advanced display screens used in laptops not only are important as
computer screens but also promise to open up huge markets in all types of display technology from cockpit,
medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV.
B. MNC Capital Budgeting and Taxation
Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California, manufacturer of disk-drive
controllers, is trying to decide whether to switch to offshore production. Given Xebec's well- developed
engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production,
taking full advantage of both low-wage labor and a grab bag of tax holidays, low-interest loans, and other
government largess. Most of his competitors seemed to be doing it. the faster he followed suit, the better off
Xebec would be according to the conventional discounted cash-flow analysis, which shows that switching
production offshore is clearly a positive NPV investment. However, Toreson is concerned that such a move
would entail the loss of certain intangible strategic benefits associated with domestic production.
a.
What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its
customers are all U.S. firms and that manufacturing technology--particularly automation skills--is key to
survival in this business.
ANSWER. Short-run benefits include better quality control, better communication with customers, and the ability
to adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a
laboratory in which to apply the latest thinking about automated production. By working with the production
process on a daily basis, Xebec would have a better sense of the technology's wider potential, of possible
applications that it would otherwise not think about. For example, running a highly automated manufacturing
operation next door to the engineering group would enable Xebec to provide production-related input in the early
stages of product design--something that offshore production managers can rarely do. And with successfully
automated production, Xebec's new disk drives could be offered with a price and quality level to match those of
potential competitors from Japan or anywhere else. By contrast, contracting to have its products built for it by a
potential competitor in a country like Taiwan or Japan might cost Xebec both market share and its technological
edge.
The video recorder is a classic example of how production know-how can yield important technical advances.
Sony, along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professional-use
product from the United States that cost $20,000 or more and turned it into a $1,500 home product with a relatively
small market. Japanese designers then worked closely with Japanese factories to make every component smaller
and less expensive. Cooperation between Matsushita's design teams and employees on the shop floor eliminated
more than three-quarters of the product's cost while dramatically improving its quality. In the process, the company
turned a niche product into the mass-market success story of the 1980s.
b.
What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing
(which are intangible costs of offshore production) into the factory location decision?
ANSWER. The intangible strategic benefits of domestic manufacturing can be factored into the factory location
decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a
series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines
and benefit from expanding into new products or markets or new process technologies. Whether Xebec will
exercise these growth options depends on what happens in the future, which is unknowable today.
The value of these growth options depends on several factors:
1.
The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before
responding to changes in the marketplace (since automation enables it to respond so quickly once it decides
to). The investment in automation also provides Xebec with a set of long-lasting skills.
2.
The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in
automation is likely to be especially valuable since it so risky.
3.
The level of interest rates. The higher the interest rate the more valuable are projects that contain growth
options.
4.
The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is
shared with others. Learning about the automation process is clearly a proprietary skill and so more valuable
than investing in a new piece of equipment that everyone has access to.
Valuing an investment in automation which embodies discretionary follow-up projects requires an expanded net
present value rule that considers the attendant options. More specifically, the value of an option to undertake a
follow-up project equals the expected NPV from investing in the project using the conventional discounted cash
flow analysis plus the value of the discretion associated with undertaking the project.
c.
How would the possibility of radical shifts in manufacturing technology affect the production location
decision?
ANSWER. The possibility of radical shifts in manufacturing technology would increase the benefits from
investing in factory automation in the U.S. The phrase "radical shifts" implies that the project is high risk, which
increases the option component of value.
For example, companies that in the mid-1970s made the transition from electro-mechanical manually operated
machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in
capabilities--much higher performance at much lower cost--of the microprocessors and microcontrollers that
became available in the early 1980s. For these companies, their operators, maintenance personnel, and process
engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to
retrofit powerful microelectronics when they became available. Companies that had deferred investment in the
emerging electronic technology were not able to participate in the great technological advances in microelectronics;
they had not acquired an option in this new process technology.
d.
Xebec is considering producing more-sophisticated drives that require substantial customization. How does
this possibility affect its production decision?
ANSWER. The more customization is required, the more important it is to work closely with the customer. To
meet the exacting needs of customers, there must be close personal contract between Xebec's engineering and
production staff and representatives of the purchasing company, something all but impossible to achieve over
10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of the
marketing, engineering, design, and manufacturing people when they are spread around the globe. The need for
coordination increases the value of domestic production facilities.
e.
Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to Xebec to build a factory
there. The loan would be paid off in equal annual installments over a five-year period. If the market interest
rate for such an investment is 14%, what is the before-tax value of the interest subsidy?
ANSWER. Borrowing at 5% when the market rate of interest is 14% saves Xebec 9% annually on the principal
balance outstanding. This leads to annual before-tax savings and their associated present values as follows:
Year
1
2
3
4
5
Principal
Interest
Savings
PV Factor
(@ 14%)
Present
Value
$10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
$900,000
720,000
540,000
360,000
180,000
.8772
.7695
.6750
.5921
.5194
$789,480
554,040
364,500
213,156
93,492
Total
$2,014,668
The value of this five-year stream of cash, discounted at 14%, is $2,014,668.
f.
Projected before-tax income from the Taiwan plant is $1 million annually, beginning at the end of the
first year. Taiwan's corporate tax rate is 25%, and there is a 20% dividend withholding tax. However,
Taiwan will exempt the plant's income from corporate tax (but not withholding tax) for the first five
years. If Xebec plans to remit all income as dividends back to the United States, how much is the tax
holiday worth?
ANSWER. Very little. Assuming that Xebec doesn't have any excess foreign tax credits (FTCs), it will
owe the difference between the 20% withholding tax on dividends and the 34% rate levied by the IRS on its
Taiwanese income. Xebec's after-tax income from Taiwan, with and without the tax holiday, will be:
Taiwan
No Tax Holiday
PBT
PAT (tax @ 25%)
Dividend
Withholding tax (@ 20%)
Net Dividend to Xebec
Tax Holiday
$1,000,000
750,000
750,000
150,000
PBT
PAT (no tax)
Dividend
Withholding tax (@ 20%)
$1,000,000
1,000,000
1,000,000
200,000
$600,000
Net Dividend to Xebec
$800,000
U.S. tax owed (@ 34%)
Direct FTC
Indirect FTC
$340,000
150,000
250,000
U.S. tax owed (@ 34%)
Direct FTC
Indirect FTC
$340,000
200,000
0
Net U.S. tax owed
($60,000)
Net U.S. tax owed
$140,000
PAT to Xebec
$600,000
PAT to Xebec
$660,000
United States
Assuming that Xebec has no use for excess foreign tax credits, the calculations show that the value of the
tax holiday to it is only about $60,000 annually.
g.
An alternative sourcing option is to shut down all domestic production and contract to have Xebec's
products built for it by a foreign supplier in a country such as Japan. What are some of the potential
advantages and disadvantages of foreign contracting vis-á-vis manufacturing in a wholly owned
foreign subsidiary?
ANSWER. See the answer to part a.