Literature ReviewThe role of a Human Resource department is ev.docx

Literature Review
The role of a Human Resource department is ever changing in
today’s volatile business environment. Over the years HR have
become a strong strategic partner within an organization by
providing functions such as recruitment, training and
development and retention. Human Resources in order to be
strategic works directly with all levels of management in an
effort to help with strategy and the growth of the company to
meet their vision. One very important aspect is talent
acquisition. Having the right people in key roles within the
company is vital to the success and growth. Performing this
function includes preparing a job description, recruiting, and
then setting compensation. Then a crucial tool used by many HR
departments is the process of job evaluations and performance
reviews.
Method of Job Analysis
When a new job is created or a vacancy occurs, it is the role of
a HR representative to fill that void. In order to perform this
function they need to first understand what role they are trying
fill and what skills and responsibilities this new role would
require. By conducting a job analysis they are able to further
define an important elements of any job and then search for the
person or people that are a good fit for the company. As
important as it is to perform a job analysis before looking for
that new candidate, it is equally as important to select the
correct job analysis method. Some popular job analysis methods
are Observation, Individual Interview and Structured
Questionnaires. Organizations choose methods based on various
guidelines that are all link to the job responsibilities, company
culture and size of the organization. Each organization must
select which methods are the best match for their candidate

search. The Observation method includes studying someone
while they perform their job in an effort to better understand the
tasks and duties necessary to this particular job. The advantages
are, the observer can obtain first hand knowledge and
information about the job being analyzed. This can provide an
accurate picture of the candidate ability to do the job at hand.
Other Job Analysis methods such as the interview or
questionnaire only allow HR to indirectly obtain this
information. With other methods there is a risk of omissions or
exaggerations are introduced either by the incumbent being
interviewed or by items on the questionnaire.
The next method is the Interview method; this method involves
conducting interviews of the person leaving this position to gain
insights into what duties they perform. Interviews can also be
conducted on other employees performing the same job but in
most cases start with the HR manager. The advantages are that
it allows the incumbent to describe tasks and duties that are not
observable. The disadvantage is the candidate can exaggerate or
omit tasks and duties. The interviewer must be skilled and ask
the proper questions.
The Structured Questionnaire method uses a standardized list of
work activities, called a task inventory, then jobholders or
supervisors may identify as related to the job. It must cover all
job related to tasks and behavior. Each task or behavior should
be described in terms of features such as difficulty, importance,
frequency, time spent and relationship to performance. The
disadvantage is that responses may be difficult to interpret and
open-ended.
Combining these methods will provide HR with a well-rounded
description and analysis the candidates. Furthermore this allows
you to get the perspective from a few different angles. These
methods help the HR managers find the ideal candidate.

Importance of Task Statements and KSA Statements
A task is an action designed to contribute a specified result to
the accomplishment of an objective. It has an identifiable
beginning and end that is a measurable component of the duties
and responsibilities of a specific job. Knowing the tasks that
have to be performed helps you to identify the KSA that the
candidate must possess in order to perform to standards. In
some cases you will train some of the required KSA.
Knowledge statements refer to an organized body of information
usually of a factual or procedural nature which, if applied,
makes adequate performance on the job possible. A body of
information applied directly to the performance of a function.
Skill statements refer to the proficient manual, verbal or mental
manipulation of data or things. Skills can be readily measured
by a performance test where quantity and quality of
performance are tested, usually within an established time limit.
Ability statements refer to the power to perform an observable
activity at the present time. This means that abilities have been
evidenced through activities or behaviors that are similar to
those required on the job.
The creation of these statements will take considerable thought
and insight. However, the rewards of conducting this due
diligence before taking on the task of hiring a new employee,
makes the process very simple and less stressful. Everything is
clearly defined and above all, measurable in the future.
Recruiting and Selection
Once the Task statements, KSA statements and the job
description are completed, the next step is to search for

candidates. I believe the best place to begin the job search is
from within the organization. My reason for this is that the
employees are already indoctrinated into organization culture.
Internal job postings are a great start to the process of
recruiting new employees. They have a great familiarity with
the company and may be able to attract potential job candidates.
The benefits of internal recruiting can be the cost which tends
to be less because you are not using an outside service or
source. Internal recruiting can promote growth from within the
organization. Many large companies encourage internal
promotion as a source of friendly corporate culture.
External sources can also be beneficial if the company is
looking for a fresh start or someone with some new ideas.
External recruiting can help to diversify an organization while
bring in needed competencies. Hiring externally can be done
through various ways such as Internet job boards and staffing
agencies. External hiring might be more costly but may provide
much outstanding candidates. Whichever the organization
decide internal or external, the position needed to be filled will
determine the order of the search. Once you have started
recruiting it is time to view your potential candidates. The key
in the selection process is to choose a strategy for screening
your candidates so that you are able to view the people that
meet the most qualifications. Organizations also make use of
many outside agencies when completing the selection process.
Drug screening and reference checks are often done by a third
party. Many companies are beginning to incorporate assessment
tests and activities into the selection process to insure
additional training is not necessary.
Performance Evaluations
Performance evaluations need to be in place to support
decisions made by management and the HR department. When
annual reviews come up it is imperative to be able to look back

at documentation created throughout the year in order to
document areas that need improvement as well as back up
reasons for raises and demotions. These evaluations can also be
used to teach as they may show areas that need improvement as
well as provide backup for recognition of a job well done.
Compensation
Compensation is a tool used by management for a variety of
purposes to help reach organization goals. Compensation is a
systematic approach to providing monetary value to employees
in exchange for work performed. Compensation may achieve
several purposes assisting in recruitment, job performance, and
job satisfaction. Compensation may be adjusted according the
business needs, goals, and available resources. Compensation
strategies have to be designed to meet the objectives of the
company. Many people associate compensation with money but
when looking for a job, many compensation packages are
designed with a package of products in mind. Salary is just one
key to total compensation. Benefits and some intangible items
help to complete these packages and make many jobs more
enticing. A benefits package that include a good health plan
might attract some employee while stock options entice others.
Non-monetary compensation strategies such as company
recognition for performance, fair treatment and safe and healthy
work environments and dress codes might attract or retain
employees. Organizations must provide the right balance to
attract and retain employees. The balance must also encourage
great performance and productivity.
References
Achieved on June 11, 2012 “Managers’ benefits: compensation
or
perks?”http://www.bworldonline.com/content.php?section=Econ
omy&title=Managers’-benefits:-compensation-or-

perks?&id=53577
Achieved on June 12, 2012 “Without Salary Increases, Will I
Lose Top
Employees?”http://resources.hrbrainbank.com/without-salary-
increases-will-i-lose-top-employees.html
Achieved on June 12, 2012 “Paying for Performance”
http://www.inc.com/magazine/20041101/benefits.html
Achieved on June 12, 2012 “The Power of Base Pay”
http://www.inc.com/articles/1999/10/19037.html
Achieved on May 28, 2012 “Management: Performance
Management”
http://www.nd.gov/hrms/managers/guide/perfeval.htmlperson-
105678.html
Achieved on May 28, 2012 “External vs. Internal Recruiting”
http://www.ere.net/2007/06/13/external-vs-internal-recruiting-
who-does-it-better/
Achieved on May 30, 2012 “Personal Selection” http://www.hr-
guide.com/data/G311.htm
Achieved on May 16, 2012 “Job Analysis and Hiring the Right
Person” http://www.articlesbase.com/management-articles/job-
analysis-and-hiring-the-right-person-105678.html
Achieved on May 17, 2012 “Zeroing In on What Your Job's
About”
http://www.mindtools.com/pages/article/newTCS_02.htm
Achieved on May 17, 2012
http://www.doi.gov/hrm/pmanager/st12d.html

CHAPTER 16 Corporate Strategy and Foreign Direct
Investment
Although investors are buying an increasing amount of foreign
stocks and bonds, most still invest overseas indirectly by
holding shares of multinational corporations. MNCs create
value for their shareholders by investing overseas in projects
that have positive net present values (NPVs)—returns in excess
of those required by shareholders. To continue to earn excess
returns on foreign projects, multinationals must be able to
transfer abroad their sources of domestic competitive
advantage. This chapter discusses how firms create, preserve,
and transfer overseas their competitive strengths.
The present focus on competitive analysis and value creation
stems from the view that generating projects that are likely to
yield economic rent—excess returns that lead to positive net
present values—is a critical part of the capital-budgeting
process. This is the essence of corporate strategy—creating and
then taking best advantage of imperfections in product and
factor markets that are the precondition for the existence of
economic rent.
This chapter examines the phenomenon of foreign direct
investment (FDI)—the acquisition abroad of plant and
equipment—and identifies those market imperfections that lead
firms to become multinational. Only if these imperfections are
well understood can a firm determine which foreign investments
are likely ex ante to have positive NPVs. The chapter also
analyzes corporate strategies for international expansion and
presents a normative approach to global strategic planning and
foreign investment analysis.
16.1 Theory of the Multinational Corporation
It has long been recognized that all MNCs are oligopolists
(although the converse is not true), but only recently have
oligopoly and multinationality been explicitly linked via the
notion of market imperfections. These imperfections can be

related to product and factor markets or to financial markets.
Product and Factor Market Imperfections
The most promising explanation for the existence of
multinationals relies on the theory of industrial organization
(IO), which focuses on imperfect product and factor markets. IO
theory points to certain general circumstances under which each
approach—exporting, licensing, or local production—will be the
preferred alternative for exploiting foreign markets.
According to this theory, multinationals have intangible capital
in the form of trademarks, patents, general marketing skills, and
other organizational abilities.1 If this intangible capital can be
embodied in the form of products without adaptation, then
exporting generally will be the preferred mode of market
penetration. When the firm's knowledge takes the form of
specific product or process technologies that can be written
down and transmitted objectively, then foreign expansion
usually will take the licensing route.
Often, however, this intangible capital takes the form of
organizational skills that are inseparable from the firm itself.
Basic skills involve knowing how best to service a market
through new-product development and adaptation, quality
control, advertising, distribution, after-sales service, and the
general ability to read changing market desires and translate
them into salable products. Because it would be difficult, if
notimpossible, to unbundle these services and sell them apart
from the firm, this form of market imperfection often leads to
corporate attempts to exert control directly via the
establishment of foreign affiliates. However, internalizing the
market for an intangible asset by setting up foreign affiliates
makes economic sense if—and only if—the benefits from
circumventing market imperfections outweigh the
administrative and other costs of central control.
A useful means to judge whether a foreign investment is
desirable is to consider the type of imperfection that the
investment is designed to overcome.2 Internalization, and hence
FDI, is most likely to be economically viable in those settings

where the possibility of contractual difficulties makes it
especially costly to coordinate economic activities via arm's-
length transactions in the marketplace.
Such “market failure” imperfections lead to both vertical and
horizontal direct investment. Vertical integration—direct
investment across industries that are related to different stages
of production of a particular good—enables the MNC to
substitute internal production and distribution systems for
inefficient markets. For instance, vertical integration might
allow a firm to install specialized cost-saving equipment in two
locations without the worry and risk that facilities may be idled
by disagreements with unrelated enterprises. Horizontal direct
investment—investment that is cross-border but within an
industry—enables the MNC to utilize an advantage such as
know-how or technology and avoid the contractual difficulties
of dealing with unrelated parties. Examples of contractual
difficulties are the MNC's inability to price know-how and to
write, monitor, and enforce use restrictions governing
technology-transfer arrangements. Thus, foreign direct
investment makes most sense when a firm possesses a valuable
asset and is better off directly controlling use of the asset rather
than selling or licensing it.
Yet the existence of market failure is not sufficient to justify
FDI. Because local firms have an inherent cost advantage over
foreign investors (who must bear, e.g., the costs of operating in
an unfamiliar, and possibly hostile, environment),
multinationals can succeed abroad only if the production or
marketing edge that they possess cannot be purchased or
duplicated by local competitors. Eventually, however, all
barriers to entry erode, and the firm must find new sources of
competitive advantage or be driven back to its home country.
Thus, to survive as multinational enterprises, firms must create
and preserve efffective barriers to direct competition in product
and factor markets worldwide.
1 Richard E. Caves, “International Corporations: The
Industrial Economics of Foreign Investment,” Economica,

February 1971, pp. 1–27.
Financial Market Imperfections
An alternative, though not necessarily competing, hypothesis
for explaining foreign direct investment relies on the existence
of financial market imperfections. As we will see in Chapter 20,
the ability to reduce taxes and circumvent currency controls
may lead to greater project cash flows and a lower cost of funds
for the MNC than for a purely domestic firm.
An even more important financial motivation for foreign direct
investment is likely to be the desire to reduce risks through
international diversification. This motivation may be somewhat
surprising because the inherent riskiness of the multinational
corporation is usually taken for granted. Exchange rate changes,
currency controls, expropriation, and other forms of government
intervention are some of the risks that purely domestic firms
rarely, if ever, encounter. Thus, the greater a firm's
international investment, the riskier its operations should be.
Yet, there is good reason to believe that being multinational
may actually reduce the riskiness of a firm. Much of the
systematic or general market risk affecting a company is related
to the cyclical nature of the national economy in which the
company is domiciled. Hence, the diversification effect
resulting from operating in a number of countries whose
economic cycles are not perfectly in phase should reduce the
variability of MNC earnings. Several studies indicate that this
result, in fact, is the case.3 Thus, because foreign cash flows
generally are not perfectly correlated with those of domestic
investments, the greater riskiness of individual projects
overseas can well be offset by beneficial portfolio effects.
Furthermore, because most of the economic and political risks
specific to the multinational corporation are unsystematic, they
can be eliminated through diversification.
The value of international diversification was made clear in
Chapter 15. Thus, the ability of multinationals to supply an
indirect means of international diversification should be
advantageous to investors. However, this corporate international

diversification will prove beneficial to shareholders only if
there are barriers to direct international portfolio investment by
individual investors. These barriers do exist and were described
in Chapter 15. However, we also saw that many of these barriers
are eroding.
Our present state of knowledge does not allow us to make
definite statements about the relative importance of financial
and nonfinancial market imperfections in stimulating foreign
direct investment. Most researchers who have studied this issue,
however, would probably agree that the nonfinancial market
imperfections are much more important than the financial ones.
In the remainder of this chapter, therefore, we will concentrate
on the effects of nonfinancial market imperfections on overseas
investment.
2 These considerations are discussed by William Kahley,
“Direct Investment Activity of Foreign Firms,” Economic
Review, Federal Reserve Bank of Atlanta, Summer 1987, pp.
36–51.
16.2 The Strategy of Multinational Enterprise
An understanding of the strategies followed by MNCs in
defending and exploiting those barriers to entry created by
product and factor market imperfections is crucial to any
systematic evaluation of investment opportunities. For one
thing, such an understanding would suggest those projects that
are most compatible with a firm's international expansion. This
ranking is useful because time and money constraints limit the
investment alternatives that a firm is likely to consider. More
important, a good understanding of multinational strategies
should help uncover new and potentially profitable projects;
only in theory is a firm fortunate enough to be presented, with
no effort or expense on its part, with every available investment
opportunity. This creative use of knowledge about global
corporate strategies is as important an element of rational
investment decision making as is the quantitative analysis of
existing project possibilities.
Linking strategic planning and capital allocation yields two

other key advantages as well. First, the true economics of
investments can be assessed more accurately for strategies than
for projects. Second, the quality of the capital budgeting
process typically improves greatly when capital expenditures
are tied directly to the development and approval of business
strategies designed to build or exploit competitive advantages.
Some MNCs rely on product innovation, others on product
differentiation, and still others on cartels and collusion to
protect themselves from competitive threats. We will now
examine three broad categories of multinationals and their
associated strategies.4
Innovation-Based Multinationals
Firms such as 3M (United States), N.V. Philips (Netherlands),
and Sony (Japan) create barriers to entry by continually
introducing new products and differentiating existing ones, both
domestically and internationally. Firms in this category spend
large amounts of money on research and development (R&D)
and have a high ratio of technical to factory personnel. Their
products typically are designed to fill a need perceived locally
that often exists abroad as well. Similarly, firms such as Wal-
Mart, Toys 'R’ Us, and Price/Costco take advantage of unique
process technologies—largely in the form of superior
information-gathering, organizational, and distribution skills—
to sell overseas.
Technological leads have a habit of eroding, however. In
addition, even the innovative multinationals retain a substantial
proportion of standardized product lines. As the industry
matures, other factors must replace technology as a barrier to
entry; otherwise, local competitors may succeed in replacing
foreign multinationals in their home markets.
3 See, for example, Benjamin I. Cohen, Multinational Firms
and Asian Exports (New Haven, Conn.: Yale University Press,
1975); and Alan Rugman, “Risk Reduction by International
Diversification,” Journal of International Business Studies, Fall
1976, pp. 75–80.
The Mature Multinationals

What strategies have enabled the automobile, petroleum, paper
and pulp, and packaged-foods industries, among others, to
maintain viable international operations long after their
innovative leads have disappeared and their products have
become standardized? Simply put, these industries have
maintained international viability by erecting the same barriers
to entry internationally as those that allowed them to remain
domestic oligopolists. A principal barrier is the presence of
economies of scale, which exist whenever a given increase in
the scale of production, marketing, or distribution results in a
less-than-proportional increase in cost. The existence of scale
economies means that there are inherent cost advantages to
being large. The more significant these scale economies are,
therefore, the greater will be the cost disadvantage faced by a
new entrant to the market.
Some companies, such as Coca-Cola, McDonald's, Nestlé, and
Procter & Gamble, take advantage of enormous advertising
expenditures and highly developed marketing skills to
differentiate their products and keep out potential competitors
that are wary of the high marketing costs of new-product
introduction. By selling in foreign markets, these firms can
exploit the premium associated with their strong brand names.
Increasingly, consumer goods firms that have traditionally
stayed home also are going abroad in an attempt to offset
slowing or declining domestic sales in a maturing U.S. market.
Such firms, which include Anheuser-Busch (maker of
Budweiser beer), Campbell Soup, and Philip Morris, find that
selling overseas enables them to utilize their marketing skills
and to take advantage of the popularity of American culture
abroad.
As we saw in Chapter 1, both the established multinationals and
the newcomers are now moving into the emerging markets of
Eastern Europe, Latin America, and Asia in a big way. For
example, Exhibit 16.1 shows the capital investments for soda
production and bottling facilities in emerging markets
announced in 1992 and early 1993 alone by PepsiCo and Coca-

Cola as they raced to ensure that there would be a bottle of cola
on every street corner around the world.
Other firms, such as Alcan and Exxon, fend off new market
entrants by exploiting economies of scale in production and
transportation. Economies of scale also explain why so many
firms invested in Western Europe in preparation for Europe
1992, when cross-border barriers to the movement of goods,
services, labor, and capital were removed. Their basic rationale
was that once Europe became a single market, the opportunities
to exploit economies of scale would be greatly expanded.
Companies that were not well positioned in the key European
markets feared that they would be at a cost disadvantage
relative to multinational rivals that were better able to exploit
these scale economies.
Still other firms take advantage of economies of scope.
Economies of scope exist whenever the same investment can
support multiple profitable activities less expensively in
combination than separately. Examples abound of the cost
advantages to producing and selling multiple products related
by a common technology, set of production facilities, or
distribution network. For example, Honda has leveraged its
investment in small-engine technology in the automobile,
motorcycle, lawn mower, marine engine, chain saw, and
generator businesses. Similarly, Matsushita has leveraged its
investment in advertising and distribution of Panasonic products
in a number of consumer and industrial markets, ranging from
personal computers to DVDs. Each dollar invested in the
Panasonic name or distribution system aids sales of dozens of
different products.
Exhibit 16.1 Planned Capital Investments for Soda Production
and Bottling in Emerging Markets Announced by Pepsico and
Coca-Cola in 1992 and 1993 (U.S. $ Millions)
*Pending removal of U.S. sanctions.
Source: Company reports. Data reported in Business Week,
August 30, 1993, p. 46.

Production economies of scope are becoming more prevalent as
flexible manufacturing systems allow the same equipment to
produce a variety of products more cheaply in combination than
separately. The ability to manufacture a wide variety of
products—with little cost penalty relative to large-scale
manufacture of a single product—opens up new markets,
customers, and channels of distribution, and with them, new
routes to competitive advantage.
A strategy that is followed by Texas Instruments, Hewlett-
Packard, Sony, and others is to take advantage of the learning
curve in order to reduce costs and drive out actual and potential
competitors. This latter concept is based on the old adage that
you improve with practice. As production experience
accumulates, costs can be expected to decrease because of
improved production methods, product redesign and
standardization, and the substitution of cheaper materials or
practices. Thus, there is a competitive payoff from rapid
growth. By increasing its share of the world market, a firm can
lower its production costs and gain a competitive advantage
over its rivals.
The consequences of disregarding these economic realities are
illustrated by U.S. television manufacturers, that (to their
sorrow) ignored the growing market for color televisions in
Japan in the early 1960s. The failure of the U.S. manufacturers
to preempt Japanese color-TV development spawned a host of
Japanese competitors—such as Sony, Matsushita, and Hitachi—
that not only came to dominate their own market but eventually
took most of the U.S. market. The moral seems to be that to
remain competitive at home, it is often necessary to challenge
potential rivals in their local markets.
To counter the danger that a foreign multinational will use high
home-country prices to subsidize a battle for market share
overseas, firms often will invest in one another's domestic
markets. This strategy is known as cross-investment. The
implied threat is that “if you undercut me in my home market,
I'll do the same in your home market.” Firms with high

domestic market share and minimal sales overseas are especially
vulnerable to the strategic dilemma illustrated by the example
of Fiat.
Application FiatS Strategic Dilemma
Suppose Toyota, the Japanese auto company, cuts prices in
order to gain market share in Italy. If Fiat, the dominant Italian
producer with minimal foreign sales, responds with its own
price cuts, it will lose profit on most of its sales. In contrast,
only a small fraction of Toyota's sales and profits are exposed.
Fiat is effectively boxed in: If it responds to the competitive
intrusion with a price cut of its own, the response will damage
it more than Toyota.
The correct competitive response is for the local firm (Fiat) to
cut price in the intruder's (Toyota's) domestic market (Japan).
Having such a capability will deter foreign competitors from
using high home-country prices to subsidize marginal cost
pricing overseas. However, this strategy necessitates investing
in the domestic markets of potential competitors. The level of
market share needed to pose a credible retaliatory threat
depends on access to distribution networks and the importance
of the market to the competitor's profitability. The easier
distribution access is and the more important the market is to
competitor profitability, the smaller the necessary market
share.5
4 These categories are described by Raymond Vernon, Storm
over the Multinationals (Cambridge, Mass.: Harvard University
Press, 1977); and Ian H. Giddy, “The Demise of the Product
Cycle Model in International Business Theory,” Columbia
Journal of World Business, Spring 1978, p. 93.
5 The notion of undercutting competitors in their home
market is explored in Gary Hamel and C. K. Prahalad, “Do You
Really Have a Global Strategy?” Harvard Business Review,
July/August 1985, pp. 139–148.
The Senescent Multinationals
Eventually, product standardization is far enough advanced or
organizational and technological skills are sufficiently

dispersed that all barriers to entry erode. What strategies do
large multinationals follow when the competitive advantages in
their product lines or markets become dissipated?
One possibility is to enter new markets where little competition
currently exists. For example, Crown Cork & Seal, the
Philadelphia-based maker of cans and bottle tops, reacted to
slowing growth and heightened competition in its U.S. business
by expanding overseas. It set up subsidiaries in countries such
as Thailand, Malaysia, Zambia, Peru, and Ecuador, guessing—
correctly, as it turned out—that in those developing and
urbanizing societies, people would eventually switch from
home-grown produce to food in cans and drinks in bottles.
However, local firms are soon capable of providing stiff
competition for those foreign multinationals that are not
actively developing new sources of differential advantage.
One strategy often followed when senescence sets in is to use
the firm's globalscanning capability to seek out lower-cost
production sites. Costs can then be minimized by combining
production shifts with rationalization and integration of the
firm's manufacturing facilities worldwide. This strategy usually
involves plants specializing in different stages of production—
for example, in assembly or fabrication—as well as in particular
components or products. Yet the relative absence of market
imperfections confers a multinational production network with
little, if any, advantage over production by purely local
enterprises. For example, many U.S. electronics and textile
firms shifted production facilities to Asian locations, such as
Taiwan and Hong Kong, to take advantage of lower labor costs
there. However, as more firms took advantage of this cost-
reduction opportunity, competition in U.S. consumer electronics
and textile markets—increasingly from Asian firms—
intensified, causing domestic prices to drop and excess profits
to be dissipated.
In general, the excess profits resulting from processing new
information are temporary. Once new market or cost-reduction
opportunities are recognized by other companies, the profit rate

declines to its normal level. Hence, few firms rely solely on
cost minimization or entering new markets to maintain
competitiveness.
The more common choice is to drop old products and turn
corporate skills to new products. Companies that follow this
strategy of continuous product rollover are likely to survive as
multinationals. Those that are unable to transfer their original
competitive advantages to new products or industries must plan
on divesting their foreign operations and returning home. But
firms that withdraw from overseas operations because of a loss
of competitive advantage should not count on a very profitable
homecoming.
Mini-Case The U.S. Tire Industry Gets Run Over
The U.S. tire industry illustrates the troubles faced by
multinational firms that have lost their source of differential
advantage. Although Europe once was a profitable market for
the Big Four U.S. tiremakers—Goodyear, Firestone, Goodrich,
and Uniroyal—each of these firms has, by now, partially or
completely eliminated its European manufacturing operations.
The reason is the extraordinary price competition resulting from
a lack of unique products or production processes and the
consequent ease of entry into the market by new firms.
Moreover, these firms then faced well-financed challenges in
the U.S. market by, among others, the French tiremaker
Michelin, the developer of the radial tire and its related
production technology. Uniroyal responded by selling off its
European tire-manufacturing operation and reinvesting its
money in businesses that were less competitive there (and,
hence, more profitable) than the tire industry. This reinvestment
includes its chemical, plastics, and industrial-products
businesses in Europe. Similarly, Goodrich stopped producing
tires for new cars and expanded its operations in polyvinyl
chloride resin and specialty chemicals. In 1986, Uniroyal and
Goodrich merged their tire units to become Uniroyal Goodrich
Tire, selling only in North America. Late in 1989, its future in
doubt, Uniroyal Goodrich sold out to Michelin. The previous

year, in early 1988, Firestone sold out to the Japanese tiremaker
Bridgestone. Goodyear is now the only one of the Big Four
tiremakers that is still a U.S. company.
Goodyear, the world's number one tire producer before
Michelin's acquisition of Uniroyal Goodrich, has maintained its
leadership by investing more than $1 billion to build the most
automated tire-making facilities in the world and is aggressively
expanding its chain of wholly owned tire stores to maintain its
position as the largest retailer of tires in the United States. It
has also invested heavily in research and development to
produce tires that are recognized as being at the cutting edge of
world-class performance. Based on product innovation and high
advertising expenditures, Goodyear dominates the high-
performance segment of the tire market; it has captured nearly
90% of the market for high-performance tires sold as original
equipment on American cars and is well represented on sporty
imports. Geography has given Goodyear and other American tire
manufacturers a giant assist in the U.S. market. Heavy and
bulky, tires are expensive to ship overseas.
Questions
1. What barriers to entry has Goodyear created or taken
advantage of?
2. Goodyear has production facilities throughout the world.
What competitive advantages might global production provide
Goodyear?
3. How do tire manufacturing facilities in Japan fit in with
Goodyear's strategy to create shareholder value?
4. How will Bridgestone's acquisition of Firestone affect
Goodyear? How might Goodyear respond to this move by
Bridgestone?
Foreign Direct Investment and Survival
Thus far, we have seen how firms are capable of becoming and
remaining multinationals. However, for many of these firms,
becoming multinational is not a matter of choice but, rather, one
of survival.
Cost Reduction.

It is apparent that if competitors gain access to lower-cost
sources of production abroad, following them overseas may be a
prerequisite for domestic survival. One strategy that is often
followed by firms for which cost is the key consideration is to
develop a global-scanning capability to seek out lower-cost
production sites or production technologies worldwide. In fact,
firms in competitive industries have to seize new,
nonproprietary, cost-reduction opportunities continually, not to
earn excess returns but to make normal profits and survive.
Economies of Scale.
A somewhat less obvious factor motivating foreign investment
is the effect of economies of scale. In a competitive market,
prices will be forced close to marginal costs of production.
Hence, firms in industries characterized by high fixed costs
relative to variable costs must engage in volume selling just to
break even. A new term describes the size that is required in
certain industries to compete effectively in the global
marketplace: world-scale. These large volumes may be
forthcoming only if the firms expand overseas. For example,
companies manufacturing products such as computers that
require huge R&D expenditures often need a larger customer
base than that provided by even a market as large as the United
States in order to recapture their investment in knowledge.
Similarly, firms in capital-intensive industries with enormous
production economies of scale may also be forced to sell
overseas in order to spread their overhead over a larger quantity
of sales.
L.M. Ericsson, the Swedish manufacturer of
telecommunications equipment, is an extreme case. The
manufacturer is forced to think internationally when designing
new products because its domestic market is too small to absorb
the enormous R&D expenditures involved and to reap the full
benefit of production scale economies. Thus, when Ericsson
developed its revolutionary AXE digital switching system, it
geared its design to achieve global market penetration.
These firms may find a foreign market presence necessary in

order to continue selling overseas. Local production can expand
sales by providing customers with tangible evidence of the
company's commitment to service the market. It also increases
sales by improving a company's ability to service its local
customers. For example, an executive from Whirlpool,
explaining why the company decided to set up operations in
Japan after exporting to it for 25 years, said, “You can only do
so much with an imported product. We decided we needed a
design, manufacturing, and corporate presence in Japan to
underscore our commitment to the Japanese market and to drive
our global strategy in Asia. You can't do that long distance.”6
Thus, domestic retrenchment can involve not only the loss of
foreign profits but also an inability to price competitively in the
home market because it no longer can take advantage of
economies of scale.
Application U.S. Chipmakers Produce in Japan
Many U.S. chipmakers have set up production facilities in
Japan. One reason is that the chip-makers have discovered that
they cannot expect to increase Japanese sales from halfway
around the world. It can take weeks for a company without
testing facilities in Japan to respond to customer complaints. A
customer must send a faulty chip back to the maker for analysis.
That can take up to three weeks if the maker's facilities are in
the United States. In the meantime, the customer will have to
shut down its assembly line, or part of it. With testing facilities
in Japan, however, the wait can be cut to a few days.
However, a testing operation alone would be inefficient; testing
machines cost millions of dollars. Because an assembly plant
needs the testing machines, a company usually moves in an
entire assembly operation. Having the testing and assembly
operations also reassures procurement officials about quality:
They can touch, feel, and see tangible evidence of the
company's commitment to service the market.
6 “Whirlpool,” Fortune (Special Advertising Section), March
18, 1993, p. S-21.
Multiple Sourcing.

Once a firm has decided to produce abroad, it must determine
where to do so. Although cost minimization will often dictate
concentrating production in one or two plants, fear of strikes
and political risks usually lead firms to follow a policy of
multiple sourcing. For example, a series of strikes against
British Ford in the late 1960s and early 1970s caused Ford to
give lower priority to rationalization of supplies. It went for
safety instead, by a policy of dual sourcing. Since that time,
Ford has modified this policy, but many other firms still opt for
several smaller plants in different countries instead of one large
plant that could take advantage of scale economies but that
would be vulnerable to disruptions.
The costs of multiple sourcing are obvious; the benefits are less
apparent, however. One benefit is the potential leverage that can
be exerted against unions and governments by threatening to
shift production elsewhere. To reach a settlement in the
previously mentioned strikes against British Ford, Henry Ford II
used the threat of withholding investments from England and
placing them in Germany. Another, more obvious, benefit is the
additional protection achieved by having several plants capable
of supplying the same product.
Having multiple facilities also gives the firm the option of
switching production from one location to another to take
advantage of transient unit-cost differences arising from, say,
real exchange rate changes or new labor contracts. This option
is enhanced, albeit at a price, by building excess capacity into
the plants.
Knowledge Seeking.
Some firms enter foreign markets in order to gain information
and experience that is expected to prove useful elsewhere. For
instance, Beecham, an English firm (now part of
GlaxoSmithKline), deliberately set out to learn from its U.S.
operations how to be more competitive, first in the area of
consumer products and later in pharmaceuticals. This
knowledge proved highly valuable in competing with American
and other firms in its European markets. Similarly, in late 1992,

the South Korean conglomerate Hyundai moved its PC division
to the United States in order to keep up with the rapidly
evolving personal computer market, whose direction was set by
the U.S. market.
The flow of ideas is not all one way, however. As Americans
have demanded better-built, better-handling, and more fuel-
efficient small cars, Ford of Europe has become an important
source of design and engineering ideas and management talent
for its U.S. parent, notably with the hugely successful Taurus
and Ford Focus.
In industries characterized by rapid product innovation and
technical break-throughs by foreign competitors, it is
imperative to track overseas developments constantly. Japanese
firms excel here, systematically and effectively collecting
information on foreign innovation and disseminating it within
their own research and development, marketing, and production
groups. The analysis of new foreign products as soon as they
reach the market is an especially long-lived Japanese technique.
One of the jobs of Japanese researchers is to tear down a new
foreign product and analyze how it works as a base on which to
develop a product of their own that will outperform the original.
In a bit of a switch, Data General's Japanese operation is giving
the company a close look at Japanese technology, enabling it to
quickly pick up and transfer back to the United States new
information on Japanese innovations in the areas of computer
design and manufacturing.
More firms are building labs in Japan and hiring its scientists
and engineers to absorb Japan's latest technologies. For
example, Texas Instruments works out production of new chips
in Japan first because, an official says, “production technology
is more advanced and Japanese workers think more about
quality control.”7 A firm that remains at home can be
blindsided by current or future competitors with new products,
manufacturing processes, or marketing procedures.
Tough competition in a foreign market is a valuable experience
in itself. For many industries, a competitive home marketplace

has proved to be as much of a competitive advantage as cheap
raw materials or technical talent. Fierce domestic competition is
one reason the U.S. telecommunications industry has not lost its
lead in technology, R&D, design, software, quality, and cost.
Japanese and European firms are at a disadvantage in this
business because they do not have enough competition in their
home markets. U.S. companies have been able to engineer a
great leap forward because they saw firsthand what the
competition could do. Thus, for telecommunications firms such
as Germany's Siemens, Japan's NEC, and France's Alcatel, a
position in the U.S. market has become mandatory.
Similarly, it is slowly dawning on consumer electronics firms
that to compete effectively elsewhere, they must first compete
in the toughest market of all: Japan. What they learn in the
process—from meeting the extraordinarily demanding standards
of Japanese consumers and battling a dozen relentless Japanese
rivals—is invaluable and will possibly make the difference
between survival and extinction.
Application A Savage Home Market Is Key to Japanese
Automakers’ Success
By 2002, Japan's top automakers were nearly alone among its
once-great industries in thriving in a country that was in the
midst of a decade-long economic slump. This performance is all
the more remarkable as it comes when Japan's automobile sales
are shrinking and the auto market is crowded with nine domestic
manufacturers, all fighting for a share of a market one-third as
large as the U.S. market. Yet, it is that brutal competition that
has enabled Toyota, Nissan, and Honda to post record profits,
have the world's most efficient factories, and boast cars that top
customer satisfaction lists. Toyota, Nissan, and Honda had
combined net income for the fiscal year ended March 2002 of
$11.64 billion, compared with a combined loss of $5.4 billion
for General Motors, Ford, and DaimlerChrysler.
Japanese executives say that it is precisely their
hypercompetitive home market that has forced them to
overachieve. Although much of their recent profit growth stems

from strong sales in the U.S. market, Japanese automakers have
remained killer competitors outside Japan largely because of the
survival tactics they have developed to adapt to the free-for-all
they face in their home market. With few high-volume models,
the Japanese have learned how to make money on niche cars
built in small numbers. Their tactics include slashing the time
they spend developing new vehicles and getting them into
production and off the assembly line. Shorter lead times, in
turn, enable them to jump on new design trends and respond to
short-lived spikes in demand. It also reduces costs. Toyota
brought one new model to market 18 months after its design was
approved, about seven months quicker than the fastest U.S. or
European manufacturers. The payoff from reducing development
time to 18 months from 25 months was to shave 10% to 20%
from development costs. That is a huge cost advantage
considering that developing a new car costs from $500 million
to more than a billion dollars.
In contrast, protectionism has worked against Japanese
pharmaceutical companies. Unlike U.S. pharmaceutical
companies, which operate within a fiercely competitive home
market that fosters an entrepreneurial spirit and scientific
innovation, sheltered Japanese pharmaceutical companies have
never had to adapt to international standards and competition,
which has left them at a competitive disadvantage.
Although it may be stating the obvious to note that operating in
a competitive marketplace is an important source of competitive
advantage, this viewpoint appears to be a minority one today.
Many companies prepared for Europe 1992 by seeking mergers,
alliances, and collaboration with competitors. Some went
further and petitioned their governments for protection from
foreign rivals and assistance in R&D. However, to the extent
that companies succeed in sheltering themselves from
competition, they endanger the basis of true competitive
advantage: dynamic improvement, which derives from
continuous effort to enhance existing skills and learn new ones.
This point is illustrated by the sorry experience of the European

film industry. In order to preserve an indigenous industry,
European governments have provided subsidies for local
filmmakers and imposed restrictions on the showing of U.S.
movies. Since 1980, however, cinema audiences for European-
made films have collapsed—falling from 475 million in 1980 to
120 million in 1994. Meanwhile, the audience for American
films has barely changed. In 1968, U.S. films took 35% of
European box-office revenues; now, because European-made
films have lost much of their audience, U.S. films take 80%,
and in some countries 90%. One reason is the very subsidies and
regulations intended to support Europe's filmmakers; they have
spawned a fragmented industry, in which producers make films
to show to one another rather than to a mass audience. In
contrast, without subsidies and regulations to protect them, U.S.
filmmakers have been forced to make films with global appeal
rather than trying for art-house successes. Their achievement is
reflected in the fact that Hollywood now earns more than half
its revenues from overseas and produced all 10 of the 10 highest
grossing movies in the world in 2007 and all 50 of the all-time
highest grossing movies worldwide.
7 Wall Street Journal, August 1, 1986, p. 6.
Keeping Domestic Customers.
Suppliers of goods or services to multinationals often will
follow their customers abroad in order to guarantee them a
continuing product flow. Otherwise, the threat of a potential
disruption to an overseas supply line—for example, a dock
strike or the imposition of trade barriers—can lead the customer
to select a local supplier, which may be a domestic competitor
with international operations. Hence, comes the dilemma:
Follow your customers abroad or face the loss of not only their
foreign but also their domestic business. A similar threat to
domestic market share has led many banks; advertising
agencies; and accounting, law, and consulting firms to set up
foreign practices in the wake of their multinational clients’
overseas expansion.
Application Bridgestone Buys Firestone

As noted earlier, in March 1988, Bridgestone, the largest
Japanese tiremaker, bought Firestone and its worldwide tire
operations. Like other Japanese companies that preceded it to
the United States, Bridgestone was motivated by a desire to
circumvent potential trade barriers and soften the impact of the
strong yen. The move also greatly expanded Bridgestone's
customer base, allowing it to sell its own tires directly to U.S.
automakers, and strengthened its product line. Bridgestone
excelled in truck and heavy-duty-vehicle tires, whereas
Firestone's strength was in passenger-car tires. But beyond
these facts, a key consideration was Bridgestone's wish to
reinforce ties with Japanese auto companies that had set up
production facilities in the United States. By 1992, these
companies, either directly or in joint ventures with U.S. firms,
had the capacity to produce about 2 million vehicles annually in
the United States.
Firestone also contributed plants in Spain, France, Italy,
Portugal, Argentina, Brazil, and Venezuela. Thus, Bridgestone's
purchase of Firestone has firmly established the company not
only in North America, but in Europe and South America as
well. Formerly, it had been primarily an Asian firm, but it had
come to acknowledge the need to service Japanese automakers
globally by operating closer to their customers’ production
facilities. The increasing globalization of the automobile market
has prompted vehicle producers and tiremakers alike to set up
production facilities in each of the three main markets: North
America, Western Europe, and Japan.
Two main factors have been responsible for this trend toward
globalization: First, transport costs are high for tires, and, as a
result, exporting ceased to be a viable long-term strategy for
supplying distant markets. Second, shifting manufacturing
overseas was the only way for the tire companies to meet the
logistic challenges posed by the adoption of just-in-time
manufacturing and inventory systems by automakers.
A series of combinations in the tire industry—including
Sumitomo Rubber's purchase of Dunlop Tire's European and

U.S. operations, Pirelli's acquisition of Armstrong Tire and
Rubber, and Continental AG's acquisition of General Tire and
Rubber and its subsequent joint venture with two Japanese
tiremakers—practically forced Bridgestone to have a major
presence in the important American market if it were to remain
a key player in the United States and worldwide. Without such a
move, its Japanese competitors might have taken Bridgestone's
share of the business of Japanese firms producing in the United
States and Europe. This result would have affected its
competitive stance in Japan as well.
A similar desire to increase its presence in the vital North
American market was behind Michelin's 1989 acquisition of
Uniroyal Goodrich. For Michelin, the addition of Uniroyal
Goodrich provided entry into the private-label tire market from
which it had been absent, as well as added sales to U.S.
automakers.
As is apparent, a foreign investment may be motivated by
considerations other than profit maximization, and its benefits
may accrue to an affiliate far removed from the scene.
Moreover, these benefits may take the form of reduced risk or
an increased cash flow, either directly or indirectly. Direct cash
flows include those based on a gain in revenues or a cost
savings. Indirect flows include those resulting from a
competitor's setback or the firm's increased leverage to extract
concessions from various governments or unions (e.g., by
having the flexibility to shift production to another location). In
computing these indirect effects, a firm must consider what
would have been the company's worldwide cash flows in the
absence of the investment.
16.3 Designing a Global Expansion Strategy
Although a strong competitive advantage today in, say,
technology or marketing skills may give a company some
breathing space, these competitive advantages will eventually
erode, leaving the firm susceptible to increased competition
both at home and abroad. The emphasis must be on
systematically pursuing policies and investments congruent with

worldwide survival and growth. This approach involves five
interrelated elements.
1. Awareness of Profitable Investments
Firms must have an awareness of those investments that are
likely to be most profitable. As we have previously seen, these
investments are ones that capitalize on and enhance the firm's
differential advantage; that is, an investment strategy should
focus explicitly on building competitive advantage. This
strategy could be geared to building volume when economies of
scale are all important or to broadening the product scope when
economies of scope are critical to success. Such a strategy is
likely to encompass a sequence of tactical projects; projects
may yield low returns when considered in isolation, but together
they may either create valuable future investment opportunities
or allow the firm to continue earning excess returns on existing
investments. Proper evaluation of a sequence of tactical projects
designed to achieve competitive advantage requires that the
projects be analyzed jointly rather than incrementally.
For example, if the key to competitive advantage is high
volume, the initial entry into a market should be assessed on the
basis of its ability to create future opportunities to build market
share and the associated benefits thereof. Alternatively, market
entry overseas may be judged according to its ability to deter a
foreign competitor from launching a market-share battle by
posing a credible retaliatory threat to the competitor's profit
base. By reducing the likelihood of a competitive intrusion,
foreign market entry may lead to higher future profits in the
home market.
In designing and valuing a strategic investment program, a firm
must be careful to consider the ways in which the investments
interact. For example, when economies of scale exist,
investment in large-scale manufacturing facilities may be
justified only if the firm has made supporting investments in
foreign distribution and brand awareness. Investments in a
global distribution system and a global brand franchise, in turn,
are often economical only if the firm has a range of products

(and facilities to supply them) that can exploit the same
distribution system and brand name.
Developing a broad product line usually requires and facilitates
(by enhancing economies of scope) investment in critical
technologies that cut across products and businesses.
Investments in R&D also yield a steady stream of new products
that raises the return on the investment in distribution. At the
same time, a global distribution capability may be critical in
exploiting new technology.
The return to an investment in R&D is largely determined by
the size of the market in which the firm can exploit its
innovation and the durability of its technological advantage. As
the technology-imitation lag shortens, a company's ability to
fully exploit a technological advantage may depend on its being
able to quickly push products embodying that technology
through distribution networks in each of the world's critical
national markets.
Individually or in pairs, investments in large-scale production
facilities, worldwide distribution, a global brand franchise, and
new technology are likely to be negative net present value
projects. Together, however, they may yield a highly positive
NPV by forming a mutually supportive framework for achieving
global competitive advantage.
2. Selecting a Mode of Entry
This global approach to investment planning necessitates
systematic evaluation of individual entry strategies in foreign
markets, comparison of the alternatives, and selection of the
optimal mode of entry. For example, in the absence of strong
brand names or distribution capabilities but with a labor-cost
advantage, Japanese television manufacturers entered the U.S.
market by selling low-cost, private-label black-and-white TVs.
A recent entry mode is the acquisition of a state-owned
enterprise. In pursuit of greater economic efficiency or to raise
cash, governments around the world are privatizing (selling to
the private sector) many of their companies. Since 1985,
governments have sold off more than half a trillion dollars in

state-owned firms. Many of the firms being privatized come
from the same industries: airlines, utilities
(telecommunications, gas, electric, water), oil, financial
services (banking, insurance), and manufacturing
(petrochemicals, steel, autos). These privatizations present new
opportunities for market entry in areas traditionally closed to
multinationals.
3. Auditing the Effectiveness of Entry Modes
A key element is a continual audit of the effectiveness of
current entry modes, bearing in mind that a market's sales
potential is at least partially a function of the entry strategy. As
knowledge about a foreign market increases or as sales potential
grows, the optimal market-penetration strategy will likely
change. By the late 1960s, for example, the Japanese television
manufacturers had built a large volume base by selling
privatelabel TVs. Using this volume base, they invested in new
process and product technologies, from which came the
advantages of scale and quality. Recognizing the transient
nature of a competitive advantage built on labor and scale
advantages, Japanese companies, such as Matsushita and Sony,
strengthened their competitive position in the U.S. market by
investing throughout the 1970s to build strong brand franchises
and distribution capabilities. The new-product positioning was
facilitated by large-scale investments in R&D. By the 1980s, the
Japanese competitive advantage in TVs and other consumer
electronics had switched from being cost based to being based
on quality, features, strong brand names, and distribution
systems.8
Application Canon Doesn't Copy Xerox
The tribulations of Xerox illustrate the dynamic nature of
Japanese competitive advantage.9 Xerox dominates the U.S.
market for large copiers. Its competitive strengths—a large
direct sales force that constitutes a unique distribution channel,
a national service network, a wide range of machines using
custom-made components, and a large installed base of leased
machines—defeated attempts by IBM and Kodak to replicate its

success by creating matching sales and service networks.
Canon's strategy, by contrast, was simply to sidestep these
barriers to entry by (1) creating low-end copiers that it sold
through office-product dealers, thereby avoiding the need to set
up a national sales force; (2) designing reliability and
serviceability into its machines, so users or nonspecialist
dealers could service them; (3) using commodity components
and standardizing its machines to lower costs and prices and
boost sales volume; and (4) selling rather than leasing its
copiers. By 1986, Canon and other Japanese firms had more
than 90% of copier sales worldwide. And having ceded the low
end of the market to the Japanese, Xerox soon found those same
competitors flooding into its stronghold sector in the middle and
upper ends of the market.
Canon's strategy points out an important distinction between
barriers to entry and barriers to imitation.10 Competitors, such
as IBM and 3M, that tried to imitate Xerox's strategy had to pay
a matching entry fee. Through competitive innovation, Canon
avoided these costs and, in fact, stymied Xerox's response.
Xerox realized that the more quickly it responded—by
downsizing its copiers, improving reliability, and developing
new distribution channels—the more quickly it would erode the
value of its leased machines and cannibalize its existing high-
end product line and service revenues. Hence, what were
barriers to entry for imitators became barriers to retaliation for
Xerox.
8 For an excellent discussion of Japanese strategy in the
U.S. TV market and elsewhere, see Hamel and Prahalad, “Do
You Really Have a Global Strategy?”
9 This example appears in Gary Hamel and C. K. Prahalad,
“Strategic Intent,” Harvard Business Review, May/June 1989,
pp. 63–76.
10 This distinction is emphasized in ibid.
4. Using Appropriate Evaluation Criteria
A systematic investment analysis requires the use of appropriate
evaluation criteria. Nevertheless, despite (or perhaps because

of) the complex interactions between investments or corporate
policies and the difficulties in evaluating proposals, most firms
still use simple rules of thumb in selecting projects to
undertake. Analytical techniques are used only as a rough
screening device or as a final checkoff before project approval.
Although simple rules of thumb are obviously easier and
cheaper to implement, there is a danger of obsolescence and
consequent misuse as the fundamental assumptions underlying
their applicability change. On the other hand, use of the
theoretically sound and recommended present value analysis is
anything but straightforward. The strategic rationale underlying
many investment proposals can be translated into traditional
capital-budgeting criteria, but it is necessary to look beyond the
returns associated with the project itself to determine its true
impact on corporate cash flows and riskiness. For example, an
investment made to save a market threatened by competition or
trade barriers must be judged on the basis of the sales that
would otherwise have been lost. In addition, export creation and
direct investment often go hand in hand. In the case of ICI, the
British chemical company, its exports to Europe were enhanced
by its strong market position there in other product lines, a
position resulting mainly from ICI's local manufacturing
facilities.
We saw earlier that some foreign investments are designed to
improve the company's competitive posture elsewhere. For
example, Air Liquide, the world's largest industrial-gas maker,
opened a facility in Japan because Japanese factories make high
demands of their gas suppliers and keeping pace with them
ensures that the French company will stay competitive
elsewhere. In the words of the Japanese unit's president, “We
want to develop ourselves to be strong wherever our
competitors are.”11 Similarly, a spokesperson said that Air
Liquide expanded its U.S. presence because the United States is
“the perfect marketing observatory.”12 U.S. electronics
companies and paper makers have found new uses for the
company's gases, and Air Liquide has brought back the ideas to

European customers.
Applying this concept of evaluating an investment on the basis
of its global impact will force companies to answer tough
questions: How much is it worth to protect our reputation for
prompt and reliable delivery? What effect will establishing an
operation here have on our present and potential competitors or
on our ability to supply competitive products, and what will be
the profit impact of this action? One possible approach is to
determine the incremental costs associated with, say, a
defensive action such as building multiple plants (as compared
with several larger ones) and then use that number as a
benchmark against which to judge how large the present value
of the associated benefits (e.g., greater bargaining leverage vis-
à-vis host governments) must be to justify the investment.
11 Wall Street Journal, November 12, 1987, p. 32.
5. Estimating the Longevity of a Competitive Advantage
The firm must estimate the longevity of its particular form of
competitive advantage. If this advantage is easily replicated,
both local and foreign competitors will soon apply the same
concept, process, or organizational structure to their operations.
The resulting competition will erode profits to a point at which
the MNC can no longer justify its existence in the market. For
this reason, the firm's competitive advantage should be
constantly monitored and maintained to ensure the existence of
an effective barrier to entry into the market. Should these entry
barriers break down, the firm must be able to react quickly and
either reconstruct them or build new ones. But no barrier to
entry can be maintained indefinitely; to remain multinational,
firms must continually invest in developing new competitive
advantages that are transferable overseas and that are not easily
replicated by the competition.
16.4 Summary and Conclusions
For many firms, becoming multinational was the end result of
an apparently haphazard process of overseas expansion.
However, as international operations provide a more important
source of profit and as competitive pressures increase, these

firms are trying to develop global strategies that will enable
them to maintain their competitive edge both at home and
abroad.
The key to developing a successful strategy is to understand and
then capitalize on those factors that have led to success in the
past. In this chapter, we saw that the rise of the multinational
firm can be attributed to a variety of market imperfections that
prevent the completely free flow of goods and capital
internationally. These imperfections include government
regulations and controls, such as tariffs and capital controls,
that impose barriers to free trade and private portfolio
investment. More significant as a spawner of multinationals are
market failures in the areas of firm-specific skills and
information. There are various transaction, contracting, and
coordinating costs involved in trying to sell a firm's managerial
skills and knowledge apart from the goods it produces. To
overcome these costs, many firms have created an internal
market, one in which these firm-specific advantages can be
embodied in the services and products they sell.
Searching for and utilizing those sources of differential
advantage that have led to prior success is clearly a difficult
process. This chapter sketched some of the key factors involved
in conducting an appropriate global investment analysis.
Essentially, such an analysis requires the establishment of
corporate objectives and policies that are congruent with one
another and with the firm's resources and that lead to the
continual development of new sources of differential advantage
as the older ones reach obsolescence.
Such a comprehensive investment approach requires large
amounts of time, effort, and money; yet, competitive pressures
and increasing turbulence in the international environment are
forcing firms in this direction. Fortunately, the supply of
managers qualified to deal with such complex multinational
issues is rising to meet the demand for their services.

CHAPTER 17 Capital Budgeting for the Multinational
Corporation
Multinational corporations evaluating foreign investments find
their analyses complicated by a variety of problems that
domestic firms rarely, if ever, encounter. This chapter examines
several such problems, including differences between project
and parent company cash flows, foreign tax regulations,
expropriation, blocked funds, exchange rate changes and
inflation, project-specific financing, and differences between
the basic business risks of foreign and domestic projects. The
purpose of this chapter is to develop a framework that allows
measuring, and reducing to a common denominator, the effects
of these complex factors on the desirability of the foreign
investment opportunities under review. In this way, projects can
be compared and evaluated on a uniform basis. The major
principle behind methods proposed to cope with these
complications is to maximize the use of available information
while reducing arbitrary cash flow and cost of capital
adjustments. Appendix 17A discusses the management of
political risk.
17.1 Basics of Capital Budgeting
Once a firm has compiled a list of prospective investments, it
must then select from among them that combination of projects
that maximizes the firm's value to its shareholders. This
selection requires a set of rules and decision criteria that
enables managers to determine, given an investment
opportunity, whether to accept or reject it. The criterion of net
present value is generally accepted as being the most
appropriate one to use because its consistent application will
lead the company to select the same investments the
shareholders would make themselves, if they had the
opportunity.
Net Present Value
The net present value (NPV) is defined as the present value of
future cash flows discounted at the project's cost of capital

minus the initial net cash outlay for the project. Projects with a
positive NPV should be accepted; projects with a negative NPV
should be rejected. If two projects are mutually exclusive, the
one with the higher NPV should be accepted. As discussed in
Chapter 14, the cost of capital is the expected rate of return on
projects of similar risk. In this chapter, we take its value as
given.
In mathematical terms, the formula for net present value is
where
I0 = the initial cash investment
Xt = the net cash flow in period t
k = the project's cost of capital
n = the investment horizon
To illustrate the NPV method, consider a plant expansion
project with the following stream of cash flows and their
present values:
Year
Cash Flow
×
Present Value Factor (10%)
=
Present Value
Cumulative Present Value
0
−$4,000,000
1.00000
− $4,000,000
− $4,000,000
1
1,200,000
0.9091
1,091,000
−2,909,000
2
2,700,000

0.8264
2,231,000
−678,000
3
2,700,000
0.7513
2,029,000
1,351,000
Assuming a 10% cost of capital, the project is acceptable.
The most desirable property of the NPV criterion is that it
evaluates investments in the same way that the company's
shareholders do; the NPV method properly focuses on cash
rather than on accounting profits and emphasizes the
opportunity cost of the money invested. Thus, it is consistent
with shareholder wealth maximization.
Another desirable property of the NPV criterion is that it obeys
the value additivity principle. That is, the NPV of a set of
independent projects is simply the sum of the NPVs of the
individual projects. This property means that managers can
consider each project on its own. It also means that when a firm
undertakes several investments, its value increases by an
amount equal to the sum of the NPVs of the accepted projects.
Thus, if the firm invests in the previously described plant
expansion, its value should increase by $1,351,000, the NPV of
the project.
Incremental Cash Flows
The most important as well as the most difficult part of an
investment analysis is to calculate the cash flows associated
with the project: the cost of funding the project; the cash
inflows during the life of the project; and the terminal, or
ending, value of the project. Shareholders are interested in how
many additional dollars they will receive in the future for the
dollars they lay out today. Hence, what matters is not the
project's total cash flow per period, but the incremental cash
flows generated by the project.
The distinction between total and incremental cash flows is a

crucial one. Incremental cash flow can differ from total cash
flow for a variety of reasons. We now examine some of them.
Cannibalization.
When Honda introduced its Acura line of cars, some customers
switched their purchases from the Honda Accord to the new
models. This example illustrates the phenomenon known as
cannibalization, a new product taking sales away from the firm's
existing products. Cannibalization also occurs when a firm
builds a plant overseas and winds up substituting foreign
production for parent company exports. To the extent that sales
of a new product or plant just replace other corporate sales, the
new project's estimated profits must be reduced by the earnings
on the lost sales.
The previous examples notwithstanding, it is often difficult to
assess the true magnitude of cannibalization because of the need
to determine what would have happened to sales in the absence
of the new product or plant. Consider Motorola's construction of
a plant in Japan to supply chips to the Japanese market
previously supplied via exports. In the past, Motorola got
Japanese business whether or not it manufactured in Japan. But
now Japan is a chip-making dynamo whose buyers no longer
have to depend on U.S. suppliers. If Motorola had not invested
in Japan, it might have lost export sales anyway. Instead of
losing these sales to local production, however, it would have
lost them to one of its rivals. The incremental effect of
cannibalization—the relevant measure for capital-budgeting
purposes—equals the lost profit on lost sales that would not
otherwise have been lost had the new project not been
undertaken. Those sales that would have been lost anyway
should not be counted a casualty of cannibalization.
Sales Creation.
Black & Decker, the U.S. power tool company, significantly
expanded its exports to Europe after investing in European
production facilities that gave it a strong local market position
in several product lines. Similarly, GM's auto plants in Britain
use parts made by its U.S. plants, parts that would not otherwise

be sold if GM's British plants disappeared.
In both cases, an investment either created or was expected to
create additional sales for existing products. Thus, sales
creation is the opposite of cannibalization. In calculations of the
project's cash flows, the additional sales and associated
incremental cash flows should be attributed to the project.
Opportunity Cost.
Suppose IBM decides to build a new office building in Sao
Paulo on some land it bought 10 years ago. IBM must include
the cost of the land in calculating the value of undertaking the
project. Also, this cost must be based on the current market
value of the land, not the price it paid 10 years ago.
This example demonstrates a more general rule. Project costs
must include the true economic cost of any resource required
for the project, regardless of whether the firm already owns the
resource or has to go out and acquire it. This true cost is the
opportunity cost, the maximum amount of cash the asset could
generate for the firm should it be sold or put to some other
productive use. It would be foolish for a firm that acquired oil
at $60 a barrel and converted it into petrochemicals to sell those
petrochemicals based on $60 a barrel oil if the price of oil has
risen to $150 per barrel. So, too, it would be foolish to value an
asset used in a project at other than its opportunity cost,
regardless of how much cash changes hands.
Transfer Pricing.
By raising the price at which a proposed Ford plant in
Dearborn, Michigan, will sell engines to its English subsidiary,
Ford can increase the apparent profitability of the new plant but
at the expense of its English affiliate. Similarly, if Matsushita
lowers the price at which its Panasonic division buys
microprocessors from its microelectronics division, the latter's
new semiconductor plant will show a decline in profitability.
These examples demonstrate that the transfer prices at which
goods and services are traded internally can significantly distort
the profitability of a proposed investment. Whenever possible,
the prices used to evaluate project inputs or outputs should be

market prices. If no market exists for the product, then the firm
must evaluate the project based on the cost savings or additional
profits to the corporation of going ahead with the project. For
example, when Atari decided to switch most of its production to
Asia, its decision was based solely on the cost savings it
expected to realize. This approach was the correct one to use
because the stated revenues generated by the project were
meaningless, an artifact of the transfer prices used in selling its
output back to Atari in the United States.
Fees and Royalties.
Often companies will charge projects for various items such as
legal counsel, power, lighting, heat, rent, research and
development, headquarters staff, management costs, and the
like. These charges appear in the form of fees and royalties.
They are costs to the project, but they are a benefit from the
standpoint of the parent firm. From an economic standpoint, the
project should be charged only for the additional expenditures
that are attributable to the project; those overhead expenses that
are unaffected by the project should not be included in
estimates of project cash flows.
Getting the Base Case Right.
In general, a project's incremental cash flows can be found only
by subtracting worldwide corporate cash flows without the
investment—the base case—from postinvestment corporate cash
flows. To come up with a realistic base case, and thus a
reasonable estimate of incremental cash flows, managers must
ask the key question, “What will happen if we don't make this
investment?” Failure to heed this question led General Motors
during the 1970s to slight investment in small cars despite the
Japanese challenge; small cars looked less profitable than GM's
then-current mix of cars. As a result, Toyota, Nissan, and other
Japanese automakers were able to expand and eventually
threaten GM's base business. Similarly, many American
companies—such as Kodak and Zenith—that thought overseas
expansion too risky or unattractive later found their domestic
competitive positions eroding. They did not adequately consider

the consequences of not building a strong global position.
The critical error made by these and other companies is to
ignore competitor behavior and assume that the base case is the
status quo. In a competitive world economy, however, the least
likely future scenario is the status quo. A company that opts not
to come out with a new product because it is afraid that the
product will cannibalize its existing product line is most likely
leaving a profitable niche for some other company to exploit.
Sales will be lost anyway, but now they will be lost to a
competitor. Similarly, a company that chooses not to invest in a
new process technology because it calculates that the higher
quality is not worth the added cost may discover that it is losing
sales to competitors who have made the investment. In a
competitive market, the rule is simple: If you must be the victim
of a cannibal, make sure the cannibal is a member of your
family.
Application Investing in Memory Chips
Since 1984, the intense competition from Japanese firms has
caused most U.S. semiconductor manufacturers to lose money in
the memory chip business. The only profitable part of the chip
business for them is in making microprocessors and other
specialized chips. Why did U.S. companies continue investing
in facilities to produce memory chips (the DRAMs) despite their
losses in this business?
Historically, U.S. companies cared so much about memory chips
because of their importance in fine-tuning the manufacturing
process. Memory chips are manufactured in huge quantities and
are fairly simple to test for defects, which makes them ideal
vehicles for refining new production processes. Having worked
out the bugs by making memories, chip companies apply an
improved process to hundreds of more complex products.
Without manufacturing some sort of memory chip, it was very
difficult to keep production technology competitive. Thus,
making profitable investments elsewhere in the chip business
was contingent on producing memory chips. As manufacturing
technology has changed, diminishing the importance of memory

chips as process technology drivers, U.S. chipmakers such as
Intel have stopped producing DRAMs.
Accounting for Intangfble Benefits.
Related to the choice of an incorrect base case is the problem of
incorporating intangible benefits in the capital-budgeting
process. Intangibles such as better quality, faster time to
market, quicker and less error-prone order processing, and
higher customer satisfaction can have tangible impacts on
corporate cash flows, even if they cannot be measured precisely.
Similarly, many investments provide intangible benefits in the
form of valuable learning experiences and a broader knowledge
base. For example, investing in foreign markets can sharpen
competitive skills: It exposes companies to tough foreign
competition, it enables them to size up new products being
developed overseas and figure out how to compete with them
before these products show up in the home market, and it can
aid in tracking emerging technologies to transfer back home.
Adopting practices, products, and technologies discovered
overseas can improve a company's competitive position
worldwide.
Application Intangible Benefits from Investing in Japan
The prospect of investing in Japan scares many foreign
companies. Real estate is prohibitively expensive. Customers
are extraordinarily demanding. The government bureaucracy can
seem impenetrable at times, and Japanese competitors fiercely
protect their home market.
An investment in Japanese operations provides a variety of
intangible benefits, however. More companies are realizing that
to compete effectively elsewhere, they must first compete in the
toughest market of all: Japan. What they learn in the process—
from meeting the stringent standards of Japanese customers and
battling a dozen relentless Japanese rivals—is invaluable and
will possibly make the difference between survival and
extinction. At the same time, operating in Japan helps a
company such as IBM keep up the pressure on some of its most
potent global competitors in their home market. A position in

the Japanese market also gives a company an early look at new
products and technologies originating in Japan, enabling it to
pick up and quickly transfer back to the United States
information on Japanese advances in manufacturing technology
and product development. And monitoring changes in the
Japanese market helps boost sales there as well.
Although the principle of incremental analysis is a simple one
to state, its rigorous application is a complicated undertaking.
However, this rule at least points those executives responsible
for estimating cash flows in the right direction. Moreover, when
estimation shortcuts or simplifications are made, it provides
those responsible with some idea of what they are doing and
how far they are straying from a thorough analysis.
Alternative Capital-Budgeting Frameworks
As we have just seen, the standard capital-budgeting analysis
involves first calculating the expected after-tax values of all
cash flows associated with a prospective investment and then
discounting those cash flows back to the present, using an
appropriate discount rate. Typically, the discount rate used is
the weighted average cost of capital (WACC), introduced in
Chapter 14, for which the weights are based on the proportion
of the firm's capital structure accounted for by each source of
capital.
An Adjusted Present Value Approach.
The weighted average cost of capital is simple in concept and
easy to apply. A single rate is appropriate, however, only if the
financial structures and commercial risks are similar for all
investments undertaken. Projects with different risks are likely
to possess differing debt capacities, therefore necessitating a
separate financial structure. Moreover, the financial package for
a foreign investment may include project-specific loans at
concessionary rates or higher-cost foreign funds because of
home country exchange controls, leading to different component
costs of capital for foreign investments.
The weighted average cost of capital figure can be modified to
reflect these deviations from the firm's typical investment, but

for some companies, such as those in extractive industries, there
is no norm. Project risks and financial structure vary by
country, raw material, production stage, and position in the life
cycle of the project. An alternative approach is to discount cash
flows using the all-equity rate,k*. This rate abstracts from the
project's financial structure and is based solely on the riskiness
of the project's anticipated cash flows. In other words, the all-
equity cost of capital equals the company's cost of capital if it
were all-equity financed, that is, with no debt.
To calculate the all-equity rate, we rely on the capital asset
pricing model (CAPM) introduced in Chapter 14:
where β* is the all-equity beta—that is, the beta associated with
the unleveraged cash flows.
Application Estimating a Foreign Project's Cost of Capital
Suppose that a foreign project has an all-equity beta of 1.15, the
risk-free return is 7%, and the required return on the market is
estimated at 15%. Then based on Equation 17.2, the projects
cost of capital is
In reality, the firm will not be able to estimate β* with the
degree of precision implied here. Instead, it will have to use
guesswork based on theory. The considerations involved in the
estimation process are discussed in the following section.
If the project is of similar risk to the average project selected by
the firm, it is possible to estimate β* by reference to the firm's
stock price beta, βe. In other words, βe is the beta that appears
in the estimate of the firm's cost of equity capital, ke, given its
current capital structure.
To transform βe into β*, we must separate out the effects of
debt financing. This operation is known as unlevering, or
converting a levered equity beta to its unlevered or all-equity
value. Unlevering can be accomplished by using the following
approximation:
where t is the firm's marginal tax rate, and D/E is its current

debt-to-equity ratio. Thus, if a firm has a stock price beta of
1.1, a debt/equity ratio of 0.6, and a marginal tax rate of 35%,
Equation 17.3 estimates its all-equity beta as 0.79 [1.1/(1 + 0.65
× 0.6)].
The all-equity rate k* can be used in capital budgeting by
viewing the value of a project as being equal to the sum of the
following components: (1) the present value of project cash
flows after taxes but before financing costs, discounted at k;”
(2) the present value of the tax savings on debt financing, which
is also known as the interest tax shield; and (3) the present
value of any savings (penalties) on interest costs associated
with project-specific financing.1 This latter differential would
generally result from government regulations and/or interest
subsidies that caused interest rates on restricted funds to
diverge from domestic interest payable on unsubsidized, arm's-
length borrowing. The adjusted present value (APV) with this
approach is
where
Tt = tax savings in year t resulting from the specific
financing package
St = before-tax dollar (home currency) value of interest
subsidies (penalties) in year t resulting from project-specific
financing
id = before-tax cost of dollar (home currency) debt
The last two terms in Equation 17.4 are discounted at the
before-tax cost of dollar debt to reflect the relatively certain
value of the cash flows resulting from tax shields and interest
savings (penalties). The interest tax shield in period t, Tt,
equals τid Dt, where τ is the corporate tax rate and Dt is the
incremental debt supported by the project in period t.
It should be emphasized that the all-equity cost of capital equals
the required rate of return on a specific project—that is, the
riskless rate of interest plus an appropriate risk premium based
on the project's particular risk. Thus, k* varies by project as
project risks vary.

According to the CAPM, the market prices only systematic risk
relative to the market rather than total corporate risk. In other
words, only interactions of project returns with overall market
returns are relevant in determining project riskiness;
interactions of project returns with total corporate returns can
be ignored. Thus, each project has its own required return and
can be evaluated without regard to the firm's other investments.
If a project-specific approach is not used, the primary advantage
of the CAPM is lost—the concept of value additivity, which
allows projects to be considered independently.
1 This material is based on Donald R. Lessard, “Evaluating
Foreign Projects: An Adjusted Present Value Approach,” in
International Financial Management, 2nd ed., edited by Donald
R. Lessard (Boston: Warren, Gorham & Lamont, 1985).
17.2 Issues in Foreign Investment Analysis
The analysis of a foreign project raises two additional issues
other than those dealing with the interaction between the
investment and financing decisions:
1. Should cash flows be measured from the viewpoint of the
project or that of the parent?
2. Should the additional economic and political risks that are
uniquely foreign be reflected in cash-flow or discount rate
adjustments?
Parent versus Project Cash Flows
A substantial difference can exist between the cash flow of a
project and the amount that is remitted to the parent firm
because of tax regulations and exchange controls. In addition,
project expenses such as management fees and royalties are
returns to the parent company. Furthermore, the incremental
revenue contributed to the parent of the multinational
corporation by a project can differ from total project revenues
if, for example, the project involves substituting local
production for parent company exports or if transfer price
adjustments shift profits elsewhere in the system.
Given the differences that are likely to exist between parent and
project cash flows, the question arises as to the relevant cash

flows to use in project evaluation. Economic theory has the
answer to this question. According to economic theory, the
value of a project is determined by the net present value of
future cash flows back to the investor. Thus, the parent MNC
should value only those cash flows that are, or can be,
repatriated net of any transfer costs (such as taxes) because only
accessible funds can be used for the payment of dividends and
interest, for amortization of the firm's debt, and for
reinvestment.
A Three-Stage Approach.
A three-stage analysis is recommended for simplifying project
evaluation. In the first stage, project cash flows are computed
from the subsidiary's standpoint, exactly as if the subsidiary
were a separate national corporation. The perspective then shifts
to the parent company. This second stage of analysis requires
specific forecasts concerning the amounts, timing, and form of
transfers to headquarters, as well as information about what
taxes and other expenses will be incurred in the transfer
process. Finally, the firm must take into account the indirect
benefits and costs that this investment confers on the rest of the
system, such as an increase or decrease in export sales by
another affiliate.
Estimating Incremental Project Cash Flows.
Essentially, the company must estimate a project's true
profitability. True profitability is an amorphous concept, but
basically it involves determining the marginal revenue and
marginal costs associated with the project. In general, as
mentioned earlier, incremental cash flows to the parent can be
found only by subtracting worldwide parent company cash flows
(without the investment) from postinvestment parent company
cash flows. This estimating entails the following:
1. Adjust for the effects of transfer pricing and fees and
royalties.
• Use market costs/prices for goods, services, and capital
transferred internally
• Add back fees and royalties to project cash flows, because

they are benefits to the parent.
• Remove the fixed portions of such costs as corporate
overhead.
2. Adjust for global costs/benefits that are not reflected in the
project's financial statements. These costs/benefits include
• Cannibalization of sales of other units
• Creation of incremental sales by other units
• Additional taxes owed when repatriating profits
• Foreign tax credits usable elsewhere
• Diversification of production facilities
• Market diversification
• Provision of a key link in a global service network
• Knowledge of competitors, technology, markets, and
products
The second set of adjustments involves incorporating the
project's strategic purpose and its impact on other units. These
strategic considerations embody the factors that were discussed
in Chapter 16. For example, AT&T is investing heavily in the
ability to provide multinational customers with seamless global
telecommunications services.
Although the principle of valuing and adjusting incremental
cash flows is itself simple, it can be complicated to apply. Its
application is illustrated in the case of taxes.
Tax Factors.
Because only after-tax cash flows are relevant, it is necessary to
determine when and which taxes must be paid on foreign-source
profits. The following example illustrates the calculation of the
incremental tax owed on foreign-source earning. Suppose an
affiliate remits after-tax earnings of $150,000 to its U.S. parent
in the form of a dividend. Assume that the foreign tax rate is
25%, the withholding tax on dividends is 4%, and excess
foreign tax credits are unavailable. The marginal rate of
additional taxation is found by adding the withholding tax that
must be paid locally to the U.S. tax owed on the dividend.
Withholding tax equals $6,000 (150,000 × 0.04), and U.S. tax
owed equals $14,000. This latter tax is calculated as follows:

With a before-tax local income of $200,000 (200,000 × 0.75 =
150,000), the U.S. tax owed would equal $200,000 × 0.35, or
$70,000. The firm then receives foreign tax credits equal to
$56,000—the $50,000 in local tax paid and the $6,000 dividend
withholding tax—leaving a net of $14,000 owed the IRS. This
calculation yields a marginal tax rate of 13.33% on remitted
profits, as follows:
If excess foreign tax credits are available to offset the U.S. tax
owed, then the marginal tax rate on remittances is just the
dividend withholding tax rate of 4%.
Political and Economic Risk Analysis
All else being equal, firms prefer to invest in countries with
stable currencies, healthy economies, and minimal political
risks, such as expropriation. All else is usually not equal,
however, and so firms must assess the consequences of various
political and economic risks for the viability of potential
investments.
The three main methods for incorporating the additional
political and economic risks, such as the risks of currency
fluctuation and expropriation, into foreign investment analysis
are (1) shortening the minimum payback period, (2) raising the
required rate of return of the investment, and (3) adjusting cash
flows to reflect the specific impact of a given risk.
Adjusting the Discount Rate or Payback Period.
The additional risks confronted abroad are often described in
general terms instead of being related to their impact on
specific investments. This rather vague view of risk probably
explains the prevalence among multinationals of two
unsystematic approaches to account for the added political and
economic risks of overseas operations. One is to use a higher
discount rate for foreign operations; another is to require a
shorter payback period. For instance, if exchange restrictions
are anticipated, a normal required return of 15% might be raised
to 20%, or a five-year payback period might be shortened to
three years.

Neither of the aforementioned approaches, however, lends itself
to a careful evaluation of the actual impact of a particular risk
on investment returns. Thorough risk analysis requires an
assessment of the magnitude and timing of risks and their
implications for the projected cash flows. For example, an
expropriation five years hence is likely to be much less
threatening than one expected next year, even though the
probability of its occurring later may be higher. Thus, using a
uniformly higher discount rate simply distorts the meaning of
the present value of a project by penalizing future cash flows
relatively more heavily than current ones, without obviating the
necessity for a careful risk evaluation. Furthermore, the choice
of a risk premium is an arbitrary one, whether it is 2% or 10%.
Instead, adjusting cash flows makes it possible to fully
incorporate all available information about the impact of a
specific risk on the future returns from an investment.
Adjusting Expected Values.
The recommended approach is to adjust the cash flows of a
project to reflect the specific impact of a given risk, primarily
because there is normally more and better information on the
specific impact of a given risk on a project's cash flows than on
its required return. The cash-flow adjustments presented in this
chapter employ only expected values; that is, the analysis
reflects only the first moment of the probability distribution of
the impact of a given risk. Although this procedure does not
assume that shareholders are risk-neutral, it does assume either
that risks such as expropriation, currency controls, inflation,
and exchange rate changes are unsystematic or that foreign
investments tend to lower a firm's systematic risk. In the latter
case, adjusting only the expected values of future cash flows
will yield a lower bound on the value of the investment to the
firm.
Although the suggestion that cash flows from politically risky
areas should be discounted at a rate that ignores those risks is
contrary to current practice, the difference is more apparent
than real. Most firms evaluating foreign investments discount

most likely (modal) rather than expected (mean) cash flows at a
risk-adjusted rate. If an expropriation or currency blockage is
anticipated, then the mean value of the probability distribution
of future cash flows will be significantly below its mode. From
a theoretical standpoint, of course, cash flows should always be
adjusted to reflect the change in expected values caused by a
particular risk; however, only if the risk is systematic should
these cash flows be further discounted.
Exchange Rate Changes and Inflation
The present value of future cash flows from a foreign project
can be calculated using a two-stage procedure: (1) Convert
nominal foreign currency cash flows into nominal home
currency terms and (2) discount those nominal cash flows at the
nominal domestic required rate of return. In order to assess the
effect of exchange rate changes on expected cash flows from a
foreign project properly, one must first remove the effect of
offsetting inflation and exchange rate changes. It is worthwhile
to analyze each effect separately because different cash flows
may be differentially affected by inflation. For example, the
depreciation tax shield will not rise with inflation, whereas
revenues and variable costs are likely to rise in line with
inflation. Or local price controls may not permit internal price
adjustments. In practice, correcting for these effects means first
adjusting the foreign currency cash flows for inflation and then
converting the projected cash flows back into dollars using the
forecast exchange rate.
Application Factoring in Currency Depreciation and Inflation
Suppose that with no inflation the cash flow in year 2 of a new
project in France is expected to be ¢1 million, and the exchange
rate is expected to remain at ¢1 = $0.85. Converted into dollars,
the ¢1 million cash flow yields a projected cash flow of
$850,000. Now suppose that French inflation is expected to be
6% annually, but project cash flows are expected to rise only
4% annually because the depreciation tax shield will remain
constant. At the same time, because of purchasing power parity
(and U.S. inflation of 1%), the euro is expected to depreciate at

the rate of 5% annually—giving rise to a forecast exchange rate
in year 2 of 0.85 × (1 − 0.05)2 = $0.7671. Then, the forecast
cash flow in year 2 becomes ¢1,000,000 × 1.042 = ¢1,081,600,
with a forecast dollar value of $829,722 (0.7671 × 1,081,600).
An alternative approach to valuing a foreign project's future
cash flows is to (1) discount the nominal foreign currency cash
flows at the nominal foreign currency required rate of return
and (2) convert the resulting foreign currency present value into
the home currency using the current spot rate. These two
approaches to valuing project cash flows should give the same
results if the international Fisher effect is assumed to hold.
17.3 Foreign Project Appraisal: The Case of International
Diesel Corporation
This section illustrates how to deal with some of the
complexities involved in foreign project analysis by considering
the case of a U.S. firm with an investment opportunity in
England. International Diesel Corporation (IDC-U.S.), a U.S.-
based multinational firm, is trying to decide whether to
establish a diesel manufacturing plant in the United Kingdom
(IDC-U.K.). IDC-U.S. expects to boost significantly its
European sales of small diesel engines (40–160 hp) from the
20,000 it is currently exporting there. At the moment, IDC-U.S.
is unable to increase exports because its domestic plants are
producing to capacity. The 20,000 diesel engines it is currently
shipping to Europe are the residual output that it is not selling
domestically.
IDC-U.S. has made a strategic decision to increase its presence
and sales overseas. A logical first target of this international
expansion is the European Community (EC). Market growth
seems assured by large increases in fuel costs and the ongoing
effects of Europe 1992 and the European Monetary Union. IDC-
U.S. executives believe that manufacturing in England will give
the firm a key advantage with customers in England and
throughout the rest of the EC.
England is the most likely production location because IDC-
U.S. can acquire a 1.4-million-square-foot plant in Manchester

from British Leyland (BL), which used it to assemble gasoline
engines before its recent closing. As an inducement to locate in
this vacant plant and thereby ease unemployment among
autoworkers in Manchester, the National Enterprise Board
(NEB) will provide a five-year loan of £5 million ($10 million)
at 3% interest, with interest paid annually at the end of each
year and the principal to be repaid in a lump sum at the end of
the fifth year. Total acquisition, equipment, and retooling costs
for this plant are estimated to equal $50 million.
Full-scale production can begin six months from the date of
acquisition because IDC-U.S. is reasonably certain it can hire
BL's plant manager and about 100 other former employees. In
addition, conversion of the plant from producing gasoline
engines to producing diesel engines should be relatively simple.
The parent will charge IDC-U.K. licensing and overhead
allocation fees equal to 7% of sales in pounds sterling. In
addition, IDC-U.S. will sell its English affiliate valves, piston
rings, and other components that account for approximately
30% of the total amount of materials used in the manufacturing
process. IDC-U.K. will be billed in dollars at the current market
price for this material. The remaining components will be
purchased locally. IDC-U.S. estimates that its all-equity
nominal required rate of return for the project will equal 12%,
based on an anticipated 3% U.S. rate of inflation and the
business risks associated with this venture. The debt capacity of
such a project is judged to be about 20%—that is, a debt-to-
equity ratio for this project of about 1:4 is considered
reasonable.
To simplify its investment analysis, IDC-U.S. uses a five-year
capital-budgeting horizon and then calculates a terminal value
for the remaining life of the project. If the project has a positive
net present value for the first five years, there is no need to
engage in costly and uncertain estimates of future cash flows. If
the initial net present value is negative, then IDC-U.S. can
calculate a break-even terminal value at which the net present
value will just be positive. This break-even value is then used

as a benchmark against which to measure projected cash flows
beyond the first five years.
We now apply the three-stage investment analysis outlined in
the preceding section: (1) Estimate project cash flows; (2)
forecast the amounts and timing of cash flows to the parent; and
(3) add to, or subtract from, these parent cash flows the indirect
benefits or costs that this project provides the remainder of the
multinational firm.
Estimation of Project Cash Flows
A principal cash outflow associated with the project is the
initial investment outlay, consisting of the plant purchase,
equipment expenditures, and working-capital requirements.
Other cash outflows include operating expenses, later additions
to working capital as sales expand, and taxes paid on its net
income.
IDC-U.K. has cash inflows from its sales in England and other
EC countries. It also has cash inflows from three other sources:
1. The tax shield provided by depreciation and interest
charges
2. Interest subsidies
3. The terminal value of its investment, net of any capital
gains taxes owed upon liquidation
Recapture of working capital is not assumed until eventual
liquidation because this working capital is necessary to
maintain an ongoing operation after the fifth year.
Initial Investment Outlay.
Total plant acquisition, conversion, and equipment costs for
IDC-U.K. were previously estimated at $50 million. The plant
and equipment will be depreciated on a straight-line basis over
a five-year period, with a zero salvage value.
Of the $50 million in net plant and equipment costs, $10 million
will be financed by NEB's loan of £5 million at 3%. The
remaining $40 million will be supplied by the parent in the form
of equity capital.
Working-capital requirements—composed of cash, accounts
receivable, and inventory—are estimated at 30% of sales, but

this amount will be partially offset by accounts payable to local
firms, which are expected to average 10% of sales. Therefore,
net investment in working capital will equal approximately 20%
of sales. The transfer price on the material sold to IDC-U.K. by
its parent includes a 25% contribution to IDC-U.S.'s profit and
overhead. That is, the variable cost of production equals 75% of
the transfer price. Lloyds Bank is providing an initial working-
capital loan of £1.5 million ($3 million). All future working-
capital needs will be financed out of internal cash flow. Exhibit
17.1 summarizes the initial investment.
Financing IDC-U.K.
Based on the information just provided, IDC-U.K.'s initial
balance sheet, in both pounds and dollars, is presented in
Exhibit 17.2. The debt ratio (debt to total assets) for IDC-U.K.
is 33:53, or 62%. Note that this debt ratio could vary from 25%,
if the parent's total investment was in the form of equity, all the
way up to 100%, if IDC-U.S. provided all of its $40 million
investment for plant and equipment as debt. In other words, as
discussed in Chapter 14, an affiliate's capital structure is not
independent; rather, it depends on its parent's investment
policies.
Exhibit 17.1 Initial Investment Outlay in IDC-U.K. (£1 = $2)
As discussed in Section 17.1 (see Equation 17.4, p. 606), the tax
shield benefits of interest write-offs are represented separately.
Assume that IDC-U.K. contributes $10.6 million to its parent's
debt capacity (0.2 × $53 million), the dollar market rate of
interest for IDC-U.K. is 8%, and the U.K. tax rate is 40%. This
calculation translates into a cash flow in the first and
subsequent years equal to $10,600,000 × 0.08 × 0.40, or
$339,000. Discounted at 8%, this cash flow provides a benefit
equal to $1.4 million over the next five years.
Interest Subsidies.
Based on a 5% anticipated rate of inflation in England and on
an expected annual 2% depreciation of the pound relative to the
dollar, the market rate on the pound loan to IDC-U.K. would

equal about 10%. Thus, the 3% interest rate on the loan by the
National Enterprise Board represents a 7% subsidy to IDC-U.K.
The cash value of this subsidy equals £350,000 (£5,000,000 ×
0.07, or approximately $700,000) annually for the next five
years, with a present value of $2.7 million.2
Exhibit 17.2 Initial Balance Sheet of IDC-U.K. (£l = $2)
Sales and Revenue Forecasts.
At a profit-maximizing price of £250 per unit in the first year
($490 at the projected year 1 exchange rate), demand for diesel
engines in England and the other EC countries is expected to
increase by 10% annually, from 60,000 units in the first year to
88,000 units in the fifth year. It is assumed here that purchasing
power parity holds with no lag and that real prices remain
constant in both absolute and relative terms. Hence, the
sequences of nominal pound prices and exchange rates,
reflecting anticipated annual rates of inflation equaling 5% and
3% for the pound and dollar, respectively, are
Year
0
1
2
3
4
5
Price (pounds)
−
250
263
276
289
304
Exchange rate (dollars)
2.00
1.96
1.92

1.89
1.85
1.82
It is also assumed here that purchasing power parity holds with
respect to the euro and other currencies of the various EC
countries to which IDC-U.K. exports. These exports account for
about 60% of total IDC-U.K. sales. Disequilibrium conditions in
the currency markets or relative price changes can be dealt with
using an approach similar to that taken in the exposure
measurement example (Spectrum Manufacturing) in Chapter 11
(see p. 420).
In the first year, although demand is at 60,000 units, IDC-U.K.
can produce and supply the market with only 30,000 units
(because of the six-month start-up period). IDC-U.S. exports
another 20,000 units to its English affiliate at a unit transfer
price of £250, leading to no profit for IDC-U.K. Because these
units would have been exported anyway, IDC-U.K. is not
credited from a capital-budgeting standpoint with any profits on
these sales. IDC-U.S. ceases its exports of finished products to
England and the EC after the first year. From year 2 on, IDC-
U.S. is counting on an expanding U.S. market to absorb the
20,000 units. Based on these assumptions, IDC-U.K.'s projected
sales revenues are shown in Exhibit 17.3, line C.
In nominal terms, IDC-U.K.'s pound sales revenues are
projected to rise at a rate of 15.5% annually, based on a
combination of the 10% annual increase in unit demand and the
5% annual increase in unit price (1.10 × 1.05 = 1.155). Dollar
revenues will increase at about 13% annually, because of the
anticipated 2% annual rate of pound depreciation.
Production Cost Estimates.
Based on the assumptions that relative prices will remain
constant and that purchasing power parity will hold continually,
variable costs of production, stated in real terms, are expected
to remain constant, whether denominated in pounds or in
dollars. Hence, the pound prices of both labor and material
sourced in England and components imported from the United

States are assumed to increase by the rate of British inflation, or
5% annually. Unit variable costs in the first year are expected to
equal £140, including £30 ($60) in components purchased from
IDC-U.S.
Exhibit 17.3 Present Value of IDC-U.K.: Project Viewpoint
*Represents overhead for less than one full year.
**Loss carryforward from year 1 of £2.8 million eliminates tax
for years 2 and 3 and reduces tax for year 4.
In addition, the license fees and overhead allocations, which are
set at 7% of sales, will rise at an annual rate of 15.5% because
pound revenues are rising at that rate. With a full year of
operation, initial overhead expenses would be expected to equal
£1.1 million. Actual overhead expenses incurred, however, are
only £600,000 because the plant does not begin operation until
midyear. These expenses are partially fixed, so their rate of
increase should be about 8% annually.
The plant and equipment, valued at £25 million, can be written
off over five years, yielding an annual depreciation charge
against income of £5 million. The cash flow associated with this
tax shield remains constant in nominal pound terms but declines
in nominal dollar value by 2% annually. With a 3% rate of U.S.
inflation, its real value is, therefore, reduced by 5% annually,
the same as its loss in real pound terms.
Annual production costs for IDC-U.K. are estimated in Exhibit
17.3, lines D to I. It should be realized, of course, that some of
these expenses, such as depreciation, are a noncash charge or,
such as licensing fees, a benefit to the overall corporation.
Total production costs rise less rapidly each year than the
15.5% annual increase in nominal revenue. This situation is due
both to the fixed depreciation charge and to the semifixed
nature of overhead expenses. Thus, the profit margin should
increase over time.
2 The present value of this subsidy is found by discounting it
at 10% and then converting the resulting pound present value
into dollars at the current spot rate of $2/£. The appropriate

discount rate is 10% because this is a pound loan. The exact
present value of this subsidy is given by the difference between
the present value of debt service on the 3% loan discounted at
10% and the face value of the loan.
Projected Net Income.
Net income for years 1 through 5 is estimated on line L of
Exhibit 17.3. The effective tax rate on corporate income faced
by IDC-U.K. in England is estimated to be 40%. The £2.8
million loss in the first year is applied against income in years
2, 3, and 4, reducing corporate taxes owed in those years.
Additions to Working Capital.
One of the major outlays for any new project is the investment
in working capital. IDC-U.K. begins with an initial investment
in working capital of £1.5 million ($3 million). Working-capital
requirements are projected at a constant 20% of sales. Thus, the
necessary investment in working capital will increase by 15.5%
annually, the rate of increase in pound sales revenue. These
calculations are shown on lines O and P of Exhibit 17.3.
Terminal Value.
Calculating a terminal value is a complex undertaking, given
the various possible ways to treat this issue. Three approaches
are available. One is to assume that the investment will be
liquidated after the end of the planning horizon and to use this
value. However, this approach just takes the question one step
further: What would a prospective buyer be willing to pay for
this project? The second approach is to estimate the market
value of the project, assuming that it is the present value of
remaining cash flows. Again, however, the value of the project
to an outside buyer may differ from its value to the parent firm,
owing to parent profits on sales to its affiliate, for instance. The
third approach is to calculate a break-even terminal value at
which the project is just acceptable to the parent and then use
that as a benchmark against which to judge the likelihood of the
present value of future cash flows exceeding that value.
Most firms try to be quite conservative in estimating terminal
values. IDC-U.K. calculates a terminal value based on the

assumption that the market value of the project will be 2.7 times
the net cash flow in year 5 (net income plus depreciation), or
£19.0 million.
Estimated Project Present Value.
We are now ready to estimate the net present value of IDC-U.K.
from the viewpoint of the project. As shown in Exhibit 17.3,
line V, the NPV of project cash flows equals −$3.2 million.
Adding to this amount the $2.7 million value of interest
subsidies and the $1.4 million present value of the tax shield on
interest payments yields an overall positive project net present
value of $0.9 million. The estimated value of the interest tax
shield would be correspondingly greater if this analysis were to
incorporate benefits derived over the full 10-year assumed life
of the project, rather than including benefits from the first five
years only. Over 10 years, the present value of the tax shield
would equal $2.3 million, bringing the overall project net
present value to $1.8 million. The latter approach is the
conceptually correct one.
Despite the favorable net present value for IDC-U.K., it is
unlikely a firm would undertake an investment that had a
positive value only because of interest subsidies or the interest
tax shield provided by the debt capacity of the project.
However, this is exactly what most firms do if they accept a
marginal project, using a weighted cost of capital. Based on the
debt capacity of the project and its subsidized financing, IDC-
U.K. would have a weighted cost of capital of approximately
10%. At this discount rate, IDC-U.K. would be marginally
profitable.
It would be misleading, however, to conclude the analysis at
this point without recognizing and accounting for differences
between project and parent cash flows and their impact on the
worth of investing in IDC-U.K. Ultimately, shareholders in
IDC-U.S. will benefit from this investment only to the extent
that it generates cash flows that are, or can be, transferred out
of England. The value of this investment is now calculated from
the viewpoint of IDC-U.S.

Estimation of Parent Cash Flows
From the parent's perspective, additional cash outflows are
recorded for any taxes paid to England or the United States on
remitted funds. IDC-U.S. has additional cash inflows as well. It
receives licensing and overhead allocation fees each year for
which it incurs no additional expenses. If it did, the expenses
would have to be charged against the fees. IDC-U.S. also profits
from exports to its English affiliate.
Loan Payments.
IDC-U.K. first will make all necessary loan repayments before
paying dividends. Specifically, IDC-U.K. will repay the £1.5
million working-capital loan from Lloyds at the end of year 2
and NEB's loan of £5 million at the end of the fifth year. Their
dollar repayment costs are estimated at $2.9 million and $9.3
million, respectively, based on the forecasted exchange rates.
These latter two loan repayments are counted as parent cash
inflows because they reduce the parent's outstanding
consolidated debt burden and increase the value of its equity by
an equivalent amount. Assuming that the parent would repay
these loans regardless, having IDC-U.K. borrow and repay
funds is equivalent to IDC-U.S. borrowing the money, investing
it in IDC-U.K., and then using IDC-U.K.'s higher cash flows
(because it no longer has British loans to service) to repay IDC-
U.S.'s debts.
Remittances to IDC-U.S.
IDC-U.K. is projected to pay dividends equal to 100% of its
remaining net cash flows after making all necessary loan
repayments. It also pays licensing and overhead allocation fees
equal, in total, to 7% of gross sales. On both of these forms of
transfer, the English government will collect a 10% withholding
tax. These remittances are shown in Exhibit 17.4. IDC-U.S.,
however, will not owe any further tax to the IRS because the
company is assumed to have excess foreign tax credits.
Otherwise, IDC-U.S. would have to pay U.S. corporate income
taxes on the dividends and fees it receives, less any credits for
foreign income and withholding taxes already paid. In this case,

IDC-U.K. losses in the first year, combined with the higher
British corporate tax rate, will assure that IDC-U.S. would owe
minimal taxes to the IRS even if it did not have any excess
foreign tax credits.
Earnings on Exports to IDC-U.K.
With a 25% margin on its exports, and assuming it has
sufficient spare-parts manufacturing capacity, IDC-U.S. has
incremental earnings on sales to IDC-U.K. equaling 25% of the
value of these shipments. After U.S. corporate tax of 35%, IDC-
U.S. generates cash flows valued at 16.5% (25% × 65%) of its
exports to IDC-U.K. These cash flows are presented in Exhibit
17.5.
Estimated Present Value of Project to IDC-U.S.
Exhibit 17.4 Dividends and Fees and Royalties Received by
IDC-U.S. (U.S. $ Millions)
*Estimated present value of future fees and royalties. These
were not incorporated in the terminal value figure of $25
million.
In Exhibit 17.6, all the various cash flows are added up, net of
tax and interest subsidies on debt; and their present value is
calculated at $13.0 million. Adding the $5 million in debt-
related subsidies ($2.4 million for the interest tax shield and
$2.6 million for the NEB loan subsidy) brings this value up to
$18.0 million. It is apparent that despite the additional taxes
that must be paid to England and the United States, IDC-U.K. is
more valuable to its parent than it would be to another owner on
a stand-alone basis. This situation is due primarily to the
various licensing and overhead allocation fees received and the
incremental earnings on exports to IDC-U.K.
Exhibit 17.5 Net Cash Flows from Exports to IDC-U.K.
Exhibit 17.6 present value of IDC-U.K.: parent viewpoint
(U.S. $ millions)
*Estimated present value of future earnings on export sales to

IDC-U.K.
Lost Sales.
There is a circumstance, however, that can reverse this
conclusion. This discussion has assumed that IDC-U.S. is now
producing at capacity and that the 20,000 diesels currently
being exported to the EC can be sold in the United States,
starting in year 2. Should this assumption not be the case (i.e.,
should 20,000 units of IDC-U.K. sales just replace 20,000 units
of IDC-U.S. sales), then the project would have to be charged
with the incremental cash flow that IDC-U.S. would have
earned on these lost exports. We now see how to incorporate
this effect in a capital-budgeting analysis.
Suppose the incremental after-tax cash flow per unit to IDC-
U.S. on its exports to the EC equals $180 at present and that
this contribution is expected to maintain its value in current
dollar terms over time. Then, in nominal dollar terms, this
margin grows by 3% annually. If we assume lost sales of 20,000
units per year, beginning in year 2 and extending through year
10, and a discount rate of 12%, the present value associated
with these lost sales equals $19.5 million. The calculations are
presented in Exhibit 17.7. Subtracting the present value of lost
sales from the previously calculated present value of $18.0
million yields a net present value of IDC-U.K. to its parent
equal to −$1.5 million (—$6.5 million ignoring the interest tax
shield and subsidy).
This example points up the importance of looking at
incremental cash flows generated by a foreign project rather
than total cash flows. An investment that would be marginally
profitable on its own, and quite profitable when integrated with
parent activities, becomes unprofitable when taking into
account earnings on lost sales.
Exhibit 17.7 Value of Lost Export Sales
*The figures in this row grow by 3 percent each year. So, 185.4
= 180(1.03), and so on.
17.4 Political Risk Analysis

It is apparent from the figures in Exhibit 17.6 that IDC-U.S.'s
English investment is quite sensitive to the potential political
risks of currency controls and expropriation. The net present
value of the project does not turn positive until well after its
fifth year of operation (assuming there are no lost sales).
Should expropriation occur or exchange controls be imposed at
some point during the first five years, it is unlikely that the
project will ever be viable from the parent's standpoint. Only if
compensation is sufficiently great in the event of expropriation,
or if unremitted funds can earn a return reflecting their
opportunity cost to IDC-U.S. with eventual repatriation in the
event of exchange controls, can this project still be viable in the
face of these risks.
The general approach recommended previously for
incorporating political risk in an investment analysis usually
involves adjusting the cash flows of the project (rather than its
required rate of return) to reflect the impact of a particular
political event on the present value of the project to the parent.
This section shows how these cash-flow adjustments can be
made for the cases of expropriation and exchange controls.
Appendix 17A discusses how companies can mitigate political
risk.
Expropriation
The extreme form of political risk is expropriation.
Expropriation is an obvious case where project and parent
company cash flows diverge. The approach suggested here
examines directly the impact of expropriation on the present
value of the project to the parent. The example of United Fruit
Company shows how the technique of adjusting expected cash
flows can be used to evaluate how expropriation affects the
value of specific projects.
Application United Fruit Company Calculates the
Consequences of Expropriation
Suppose that United Fruit Company (UFC) is worried that its
banana plantation in Honduras will be expropriated during the
next 12 months.3 The Honduran government has promised,

however, that compensation of $100 million will be paid at the
year's end if the plantation is expropriated. UFC believes that
this promise would be kept. If expropriation does not occur this
year, it will not occur any time in the foreseeable future. The
plantation is expected to be worth $300 million at the end of the
year. A wealthy Honduran has just offered UFC $128 million
for the plantation. If UFC's risk-adjusted discount rate is 22%,
what is the probability of expropriation at which UFC is just
indifferent between selling now or holding onto its plantation?
Exhibit 17.8 displays UFCs two choices and their consequences.
If UFC sells out now, it will receive $128 million today.
Alternatively, if it chooses to hold on to the plantation, its
property will be worth $300 million if expropriation does not
occur and worth only $100 million in the event the Honduran
government expropriates its plantation and compensates UFC. If
the probability of expropriation is p, then the expected end-of-
year value of the plantation to UFC (in millions of dollars) is
100p + 300(1 − p) = 300 − 200p. The present value of the
amount, using UFC's discount rate of 22%, is (300 −
200p)/1.22. Setting this equal to the $128 million offer by the
wealthy Honduran yields a value of p = 72%. In other words, if
the probability of expropriation is at least 72%, UFC should sell
out now for $128 million. If the probability of expropriation is
less than 72%, it would be more worthwhile for UFC to hold on
to its plantation.
Exhibit 17.8 United Fruit Company's Choices (U.S. $
Millions)
3 Application suggested by Richard Roll.
Blocked Funds
The same method of adjusting expected cash flows can be used
to analyze the effects of various exchange controls that lead to
blocked funds. This methodology is illustrated by the example
of Brascan. In any discussion of blocked funds, it must be
pointed out that if all funds are expected to be blocked in
perpetuity, then the value of the project is zero.

Application Brascan Calculates the Consequences of
Currency Controls
Suppose that on January 1, 2009, the Indonesian electrical
authority expropriated a powergenerating station owned by
Brascan, Inc., a Canadian operator of foreign electric
facilities.4 In compensation, a perpetuity of C$50 million will
be paid annually at the end of each year. Brascan believes,
however, that the Indonesian Central Bank may block currency
repatriations during the calendar year 2011, allowing only 75%
of each year's payment to be repatriated (and no repatriation of
reinvestments from the other 25%). Assuming a cost of capital
of 20% and a probability of currency blockage of 40%, what is
the current value (on January 1, 2009) of Indonesia's
compensation?
Exhibit 17.9 displays the two possibilities and their
consequences for the cash flows Brascan expects to receive. If
currency controls are not imposed, Brascan will receive C$50
million annually, with the first payment due December 31,
2009. The present value of this stream of cash equals C$250
million (50/0.2). Alternatively, if controls are imposed, Brascan
will receive C$50 million at the end of the first two years and
C$37.5 million (50 × 0.75) on each December 31 thereafter. The
present value of these cash flows is C$206.6 million [50/1.2 +
50/(1.2)2 + (37.5/0.2)/(1.2)2].5 Weighting these present values
by the probability that each will come to pass yields an
expected present value (in millions of Canadian dollars) of 0.6
× 250 + 0.4 × 206.6 = C$232.6 million.
Exhibit 17.9 Cash Flows to Brascan (C$ Millions)
4 Application suggested by Richard Roll.
5 As of the end of year 2 the $37.5 million annuity
beginning in year 3 has a present value equal to 37.5/0.2. The
present value of this annuity as of January 1, 2009 equals
[37.5/0.2]/(1.2)2.
17.5 Growth Options and Project Evaluation
The discounted cash flow (DCF) analysis presented so far treats

a project's expected cash flows as given at the outset. This
approach presupposes a static approach to investment decision
making: It assumes that all operating decisions are set in
advance. In reality, however, the opportunity to make decisions
contingent on information to become available in the future is
an essential feature of many investment decisions.
Consider the decision of whether to reopen a gold mine. The
cost of doing so is expected to be $1 million. There are an
estimated 40,000 ounces of gold remaining in the mine. If the
mine is reopened, the gold can be removed in one year at a
variable cost of $390 per ounce. Assuming an expected gold
price in one year of $400/ounce, the expected profit per ounce
mined is $10. Clearly, the expected cash inflow (ignoring taxes)
of $400,000 next year ($10 × 40,000) is far below that
necessary to recoup the $1 million investment in reopening the
mine, much less to pay the 15% yield required on such a risky
investment. However, intuition—which suggests a highly
negative project NPV of −$652,174 (—$1,000,000 +
400,000/1.15)—is wrong in this case. The reason is that the
cash-flow projections underlying the classical DCF analysis
ignore the option not to produce gold if it is unprofitable to do
so.
Here is a simple example that demonstrates the fallacy of
always using expected cash flows to judge an investment's
merits. Suppose there are only two possible gold prices next
year: $300/ounce and $500/ounce, each with probability 0.5.
The expected gold price is $400/ounce, but this expected price
is irrelevant to the optimal mining decision rule: Mine gold if,
and only if, the price of gold at year's end is $500/ounce.
Exhibit 17.10 shows the cash-flow consequences of that
decision rule. Closure costs are assumed to be zero.
Incorporating the mine owner's option not to mine gold when
the price falls below the cost of extraction reveals a positive net
present value of $913,043 for the decision to reopen the gold
mine:

As the example of the gold mine demonstrates, the ability to
alter decisions in response to new information may contribute
significantly to the value of a project. Such investments bear
the characteristics of options on securities and should be valued
accordingly. As we saw in the case of foreign exchange, a call
option gives the holder the right, but not the obligation, to buy a
security at a fixed, predetermined price (called the exercise
price) on or before some fixed future date. By way of analogy,
the opportunities a firm may have to invest capital to increase
the profitability of its existing product lines and benefit from
expanding into new products or markets may be thought of as
growth options.6 Similarly, a firm's ability to capitalize on its
managerial talent, experience in a particular product line, its
brand name, technology, or its other resources may provide
valuable but uncertain future prospects.
Exhibit 17.10 The Gold Mine Operating Decision
Growth options are of great importance to multinational firms.
Consider the value of IDC-U.K.'s production and market
positions at the end of its planning horizon. IDC-U.S. may
increase or decrease the diesel plant's output depending on
current market conditions; expectations of future demand; and
relative cost changes, such as those resulting from currency
movements. The plant can be expanded; it can be shut down and
then reopened when production and market conditions are more
favorable; or it can be abandoned permanently. Each decision is
an option from the viewpoint of IDC-U.S. The value of these
options, in turn, affects the value of the investment in IDC-U.K.
Moreover, by producing locally, IDC-U.S. will have an
enhanced market position in the EC that may enable the
company to expand its product offerings at a later date. The
ability to exploit this market position depends on the results of
IDC-U.S.'s R&D efforts and the shifting pattern of demand for
its products. In all these cases, the optimal operating policy
depends on outcomes that are not known at the project's
inception.

Similarly, the investments that many Western firms have made
in Eastern Europe can also be thought of as growth options.
Some viewed investments there as a way to gain entry into a
potentially large market. Others saw Eastern Europe as an
underdeveloped area with educated and skilled workers but low
wages, and they viewed such investments as a low-cost
backdoor to Western European markets. In either case,
companies that invested there have bought an option that will
pay off in the event that Eastern European markets boom or that
Eastern European workers turn out to be much more productive
with the right technology and incentives than they were under
communism. Other investments are undertaken, in part, to gain
knowledge that can later be capitalized on elsewhere. For
example, in announcing its plans to build in Alabama, Mercedes
officials said the factory would serve as a laboratory for
learning to build cars more efficiently. Similarly, several
Regional Bell Operating Companies (RBOCs) such as SBC
Communications and USWest Communications established
operations in Great Britain to learn how—and whether—to
provide services such as cable TV, combined cable TV and
telephone service, and personal communications services (PCS)
that were prohibited to RBOCs in the U.S. market. By failing to
take into account the benefits of operating flexibility, learning,
and potentially valuable add-on projects, the traditional DCF
will tend to understate project values.
The problem of undervaluing investment projects using the
standard DCF analysis is particularly acute for strategic
investments. Many strategically important investments, such as
investments in R&D, factory automation, a brand name, or a
distribution network, provide growth opportunities because they
are often only the first link in a chain of subsequent investment
decisions.
Valuing investments that embody 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

project NPV using the conventional discounted cash-flow
analysis plus the value of the discretion associated with
undertaking the project. This relation is shown in Exhibit 17.11.
Based on the discussion of currency options in Chapter 8, the
latter element of value (the discretion to invest or not invest in
a project) depends on the following:
• The length of time the project can be deferred: The ability
to defer a project gives the firm more time to examine the
course of future events and to avoid costly errors if unfavorable
developments occur. A longer time interval also raises the odds
that a positive turn of events will dramatically boost the
project's profitability and turn even a negative NPV project into
a positive one.
• The risk of the project: Surprisingly, the riskier the
investment, the more valuable is an option on it. The reason is
the asymmetry between gains and losses. A large gain is
possible if the project's NPV becomes highly positive, whereas
losses are limited by the option not to exercise when the project
NPV is negative. The riskier the project, the greater the odds of
a large gain without a corresponding increase in the size of the
potential loss. Thus, growth options are likely to be especially
valuable for MNCs because of the large potential variation in
costs and the competitive environment.
• The level of interest rates: Although a high discount rate
lowers the present value of a project's future cash flows, it also
reduces the present value of the cash outlay needed to exercise
an option. The net effect is that high interest rates generally
raise the value of projects that contain growth options.
• The proprietary nature of the option: An exclusively
owned option is clearly more valuable than one that is shared
with others. The latter might include the chance to enter a new
market or to invest in a new production process. Shared options
are less valuable because competitors can replicate the
investments and drive down returns. For the multinational firm,
however, most growth options arise out of its intangible assets.
These assets, which take the form of skills, knowledge, brand

names, and the like, are difficult to replicate and so are likely to
be more valuable.
Exhibit 17.11 Valuing a Growth Option to Undertake a Follow-
Up Project
Application Ford Gives Up on Small-Car Development
In late 1986, Ford gave up on small-car development in the
United States and handed over the job to Japan.s Mazda, in
which Ford owned a 25% stake. Although seemingly cost
effective in the short run (Ford would save about $500 million
in development costs for one car model alone), such a move—
which removed a critical mass from Ford's own engineering
efforts—could prove dangerous in the longer term. Overcoming
engineering obstacles unique to sub-compact cars—for example,
the challenges of miniaturization—enhances engineers’ skills
and allows them to apply innovations to all classes of vehicles.
By eroding its technological base, Ford yielded the option of
generating ideas that can be applied elsewhere in its business.
Moreover, the cost of reentering the business of in-house design
can be substantial. The abandonment option is not one to be
exercised lightly.
Some American consumer-electronics companies, for example,
are learning the penalties of ceding major technologies and the
experiences that come from working with these technologies on
a day-to-day basis. Westinghouse Electric (now CBS), after
quitting the development and manufacture of color television
tubes in 1976, later decided to get back into the color-video
business. However, because it lost touch with the product,
Westinghouse was able to reenter only by way of a joint venture
with Japan's Toshiba.
Similarly, RCA and other U.S. manufacturers years ago
conceded to the Japanese development of videocassette
recorders and laser video disk players. Each technology has
since spawned entirely new, popular product lines—from video
cameras to compact disk players—in which U.S. companies are
left with nothing to do beyond marketing Japanese-made goods.

To take another example, RCA and Westinghouse first
discovered the principles of liquid crystal displays (LCDs) in
the 1960s. But the Americans did not follow up with investment
and development, whereas Japanese companies did. Sharp,
Seiko, and Casio used LCDs in calculators and digital watches.
That gave them knowledge of the technology so that later, when
laptop computers developed needs for sophisticated graphics
and color pictures, Japanese manufacturers could deliver
increasingly capable screens.
Even those companies that merely turn to outside partners for
technical help could nevertheless find their skills atrophying
over the years as their partners handle more of the complex
designing and manufacturing. Such companies range from
Boeing, which has enlisted three Japanese firms to help
engineer a new plane, to Honeywell, which is getting big
computers from NEC. The corresponding reduction in in-house
technological skills decreases the value of the option these
firms have to develop and apply new technologies in novel
product areas.
6 A good discussion of growth options is contained in W.
Carl Kester, “Today's Options for Tomorrow's Growth,”
Harvard Business Review, March/April 1984, pp. 153–160.
Capital budgeting for the multinational corporation presents
many elements that rarely, if ever, exist in domestic capital
budgeting. The primary thrust of this chapter has been to adjust
project cash flows instead of the discount rate to reflect the key
political and economic risks that MNCs face abroad. Tax factors
are also incorporated via cash-flow adjustments. Cash-flow
adjustments are preferred on the pragmatic grounds that more
and better information is available on the effect of such risks on
future cash flows than on the required discount rate.
Furthermore, adjusting the required rate of return of a project to
reflect incremental risk does not usually allow for adequate
consideration of the time pattern and magnitude of the risk
being evaluated. Using a uniformly higher discount rate to

reflect additional risk involves penalizing future cash flows
relatively more heavily than present ones.
This chapter showed how these cash-flow adjustments can be
carried out by presenting a lengthy numerical example. It also
discussed the significant differences that can exist between
project and parent cash flows and showed how these differences
can be accounted for when estimating the value to the parent
firm of a foreign investment. The chapter also pointed out that
failure to take into account the options available to managers to
adjust the scope of a project will lead to a downward bias in
estimating project cash flows. These options include the
possibility of expanding or contracting the project or
abandoning it, the chance to employ radical new process
technologies by utilizing skills developed from implementing
the project, and the possibility of entering the new lines of
business to which a project may lead.
Preinvestment Planning
Given the recognition of political risk, an MNC can follow at
least four separate, though not necessarily mutually exclusive,
policies: (1) avoidance, (2) insurance, (3) negotiating the
environment, and (4) structuring the investment.
Avoidance.
The easiest way to manage political risk is to avoid it, and many
firms do so by screening out investments in politically uncertain
countries. However, inasmuch as all governments make
decisions that influence the profitability of business, all
investments, including those made in the United States, face
some degree of political risk. For example, U.S. steel companies
have had to cope with stricter environmental regulations
requiring the expenditure of billions of dollars for new
pollution control devices, and U.S. oil companies have been
beleaguered by so-called windfall profit taxes, price controls,
and mandatory allocations. Thus, political risk avoidance is
impossible.
The real issue is the degree of political risk a company is
willing to tolerate and the return required to bear it. A policy of

staying away from countries considered to be politically
unstable ignores the potentially high returns available and the
extent to which a firm can control these risks. After all,
companies are in business to take risks, provided these risks are
recognized, intelligently managed, and provide compensation.
Insurance.
An alternative to risk avoidance is insurance. Firms that insure
assets in politically risky areas can concentrate on managing
their businesses and forget about political risk—or so it
appears. Most developed countries sell political risk insurance
to cover the foreign assets of domestic companies. The coverage
provided by the U.S. government through the Overseas Private
Investment Corporation (OPIC) is typical. The OPIC program
provides U.S. investors with insurance against loss resulting
from the specific political risks of expropriation, currency
inconvertibility, and political violence—that is, war, revolution,
or insurrection. To qualify, the investment must be a new one or
a substantial expansion of an existing facility and must be
approved by the host government. Coverage is restricted to 90%
of equity participation. For very large investments or for
projects deemed especially risky, OPIC coverage may be limited
to less than 90%. The only exception is institutional loans to
unrelated third parties, which may be insured for the full
amount of principal and interest.
Similar OPIC political risk protection is provided for leases.
OPIC's insurance provides lessors with coverage against loss
resulting from various political risks, including the inability to
convert into dollars local currency received as lease payments.
OPIC also provides business income coverage (BIC), which
protects a U.S. investor's income flow if political violence
causes damage that interrupts operation of the foreign
enterprise. For example, an overseas facility could be bombed
and partially or totally destroyed. It may take weeks or months
to rebuild the plant, but during the rebuilding process the
company still must meet its interest and other contractual
payments and pay skilled workers in order to retain their

services pending reopening of the business. BIC allows a
business to meet its continuing expenses and to make a normal
profit during the period its operations are suspended. This is
similar to the business interruption insurance available from
private insurers for interruptions caused by nonpolitical events.
Two fundamental problems arise when one relies exclusively on
insurance as a protection from political risk. First, there is an
asymmetry involved. If an investment proves unprofitable, it is
unlikely to be expropriated. Because business risk is not
covered, any losses must be borne by the firm itself. On the
other hand, if the investment proves successful and is then
expropriated, the firm is compensated only for the value of its
assets. This result is related to the second problem: Although
the economic value of an investment is the present value of its
future cash flows, only the capital investment in assets is
covered by insurance. Thus, although insurance can provide
partial protection from political risk, it falls far short of being a
comprehensive solution.
Negotiating the Environment.
In addition to insurance, therefore, some firms try to reach an
understanding with the host government before undertaking the
investment, defining rights and responsibilities of both parties.
Also known as a concession agreement, such an understanding
specifies precisely the rules under which the firm can operate
locally.
In the past, these concession agreements were quite popular
among firms investing in less-developed countries, especially in
colonies of the home country. They often were negotiated with
weak governments. In time, many of these countries became
independent or their governments were overthrown. Invariably,
the new rulers repudiated these old concession agreements,
arguing that they were a form of exploitation.
Concession agreements still are being negotiated today, but they
seem to carry little weight among Third World countries. Their
high rate of obsolescence has led many firms to pursue a more
active policy of political risk management.

Structuring the Investment.
Once a firm has decided to invest in a country, it then can try to
minimize its exposure to political risk by increasing the host
government's cost of interfering with company operations. This
action involves adjusting the operating policies (in the areas of
production, logistics, exporting, and technology transfer) and
the financial policies to closely link the value of the foreign
project to the multinational firm's continued control. In effect,
the MNC is trying to raise the cost to the host government of
exercising its ever-present option to expropriate or otherwise
reduce the local affiliate's value to its parent.7
One key element of such a strategy is keeping the local affiliate
dependent on sister companies for markets or supplies or both.
Chrysler, for example, managed to hold on to its Peruvian
assembly plant even though other foreign property was being
nationalized. Peru ruled out expropriation because of Chrysler's
stranglehold on the supply of essential components. Only 50%
of the auto and truck parts were manufactured in Peru. The
remainder—including engines, transmissions, sheet metal, and
most accessories—were supplied from Chrysler plants in
Argentina, Brazil, and Detroit. In a similar instance of vertical
integration, Ford's Brazilian engine plant generates substantial
exports, but only to other units of Ford. Not surprisingly, the
data reveal no expropriations of factories that sell more than
10% of their output to the parent company.8
Similarly, by concentrating R&D facilities and proprietary
technology, or at least key components thereof, in the home
country, a firm can raise the cost of nationalization. This
strategy will be effective only if other multinationals with
licensing agreements are not permitted to service the
nationalized affiliate. Another element of this strategy is
establishing a single, global trademark that cannot be legally
duplicated by a government. In this way, an expropriated
consumer-products company would sustain significant losses by
being forced to operate without its recognized brand name.
Control of transportation—including shipping, pipelines, and

railroads—has also been used at one time or another by the
United Fruit Company and other multinationals to gain leverage
over governments. Similarly, sourcing production in multiple
plants reduces the government's ability to hurt the worldwide
firm by seizing a single plant, and, thereby, it changes the
balance of power between government and firm.
Another defensive ploy is to develop external financial
stakeholders in the venture's success. This defense involves
raising capital for a venture from the host and other
governments, international financial institutions, and customers
(with payment to be provided out of production) rather than
employing funds supplied or guaranteed by the parent company.
In addition to spreading risks, this strategy will elicit an
international response to any expropriation move or other
adverse action by a host government. A last approach,
particularly for extractive projects, is to obtain unconditional
host government guarantees for the amount of the investment
that will enable creditors to initiate legal action in foreign
courts against any commercial transactions between the host
country and third parties if a subsequent government repudiates
the nation's obligations. Such guarantees provide investors with
potential sanctions against a foreign government, without
having to rely on the uncertain support of their home
governments.
7 Arvind Mahajan, “Pricing Expropriation Risk,” Financial
Management, Winter 1990, pp. 77–86, points out that when a
multinational firm invests in a country, it is effectively writing
a call option to the government on its property. The aim of
political risk management is to reduce the value to the
government of exercising this option.
8 David Bradley, “Managing Against Expropriation,”
Harvard Business Review, July/August, 1977, pp. 75–83.
Operating Policies
After the multinational has invested in a project, its ability to
further influence its susceptibility to political risk is greatly
diminished but not ended. It still has at least three different

policies that it can pursue with varying chances of success: (1)
changing the benefit/cost ratio of expropriation, (2) developing
local stakeholders, and (3) adaptation.
Before examining these policies, it is well to recognize that the
company can do nothing and hope that even though the local
regime can take over an affiliate (with minor cost), it will
choose not to do so. This wish is not necessarily in vain because
it rests on the premise that the country needs foreign direct
investment and will be unlikely to receive it if existing
operations are expropriated without fair and full compensation.
However, this strategy is essentially passive, resting on a belief
that other multinationals will hurt the country (by withholding
potential investments) if the country nationalizes local
affiliates. Whether this passive approach will succeed is a
function of how dependent the country is on foreign investment
to realize its own development plans and the degree to which
economic growth will be sacrificed for philosophical or
political reasons.
A more active strategy is based on the premise that
expropriation is basically a rational process—that governments
generally seize property when the economic benefits outweigh
the costs. This premise suggests two maneuvers characteristic of
active political risk management: (1) increase the benefits to the
government if it does not nationalize a firm's affiliate and (2)
increase the costs if it does.
Application Beijing Jeep
After the United States restored diplomatic relations with China
in 1979, Western businesses rushed in to take advantage of the
world's largest undeveloped market. Among them was American
Motors Corporation (AMC). In 1983, AMC and Beijing
Automotive Works formed a joint venture called the Beijing
Jeep Company to build and sell jeeps in China.9 The aim of
Beijing Jeep was first to modernize the old Chinese jeep, the
BJ212, and then to replace it with a “new, second-generation
vehicle” for sale in China and overseas. Because it was one of
the earliest attempts to combine Chinese and foreign forces in

heavy manufacturing, Beijing Jeep became the flagship project
other U.S. firms watched to assess the business environment in
China. Hopes were high.
AMC viewed this as a golden opportunity: Build jeeps with
cheap labor and sell them in China and the rest of the Far East.
The Chinese government wanted to learn modern automotive
technology and earn foreign exchange. Most important, the
People's Liberation Army wanted a convertible-top, four-door
jeep, so that Chinese soldiers could jump in and out and open
fire from inside the car.
That the army had none of these military vehicles when it
entered Tienanmen Square in 1989 has to do with the fact that
this jeep could not be made from any of AMC's existing jeeps.
However, in signing the initial contracts, the two sides glossed
over this critical point. They also ignored the realities of
China's economy. For managers and workers, productivity was
much lower than anybody at AMC had ever imagined.
Equipment maintenance was minimal. Aside from windshield
solvents, spare-tire covers, and a few other minor parts, no parts
could be manufactured in China. The joint venture, therefore,
had little choice but to turn the new Beijing jeep into the
Cherokee Jeep, using parts kits imported from the United States.
The Chinese were angry and humiliated not to be able to
manufacture any major jeep components locally.
They got even angrier when Beijing Jeep tried to force its
Chinese buyers to pay half of the Cherokee's $19,000 sticker
price in U.S. dollars. With foreign exchange in short supply, the
Chinese government ordered its state agencies, the only
potential customers, not to buy any more Cherokees and refused
to pay the $2 million that various agencies owed on 200
Cherokees already purchased.
The joint venture would have collapsed right then had Beijing
Jeep not been such an important symbol of the government's
modernization program. After deciding it could not let the
venture fail, China's leadership arranged a bailout. The Chinese
abandoned their hopes of making a new military jeep, and AMC

gained the right to convert renminbi (the Chinese currency) into
dollars at the official (and vastly overvalued) exchange rate.
With this right, AMC realized it could make more money by
replacing the Cherokee with the old, and much cheaper to build,
BJ212s. The BJ212s were sold in China for renminbi, and these
profits were converted into dollars.
It was the ultimate irony: An American company that originally
expected to make huge profits by introducing modern
technology to China and by selling its superior products to the
Chinese found itself surviving, indeed thriving, by selling the
Chinese established Chinese products. AMC succeeded because
its venture attracted enough attention to turn the future of
Beijing Jeep into a test of China's open-door policy.
9 This example is adapted from Jim Mann, Beijing Jeep: The
Short, Unhappy Romance of American Business in China (New
York: Simon and Schuster, 1989).
Changing the Benefit/Cost Ratio.
If the government's objectives in an expropriation are rational—
that is, based on the belief that economic benefits will more
than compensate for the costs—the multinational firm can
initiate a number of programs to reduce the perceived
advantages of local ownership and thereby diminish the
incentive to expel foreigners. These steps include establishing
local R&D facilities, developing export markets for the
affiliate's output, training local workers and managers,
expanding production facilities, and manufacturing a wider
range of products locally as substitutes for imports. Many of the
foregoing actions lower the cost of expropriation and,
consequently, reduce the penalty for the government. A delicate
balance must be observed.
Realistically, however, it appears that those countries most
liable to expropriation view the benefits—real, imagined, or
both—of local ownership as more important than the cost of
replacing the foreign investor. Although the value of a
subsidiary to the local economy can be important, its worth may
not be sufficient to protect it from political risk. Thus, one

aspect of a protective strategy must be to engage in actions that
raise the cost of expropriation by increasing the negative
sanctions it would involve. These actions include control over
export markets, transportation, technology, trademarks and
brand names, and components manufactured in other nations.
Some of these tactics may not be available once the investment
has been made, but others still may be implemented. However,
an exclusive focus on providing negative sanctions may well be
self-defeating by exacerbating the feelings of dependence and
loss of control that often lead to expropriation in the first place.
When expropriation appears inevitable, with negative sanctions
only buying more time, it may be more productive to prepare for
negotiations to establish a future contractual-based relationship.
Developing Local Stakeholders.
A more positive strategy is to cultivate local individuals and
groups that have a stake in the affiliate's continued existence as
a unit of the parent MNC. Potential stakeholders include
consumers, suppliers, the subsidiary's local employees, local
bankers, and joint venture partners.
Consumers worried about a change in product quality or
suppliers concerned about a disruption in their production
schedules (or even a switch to other suppliers) brought about by
a government takeover may have an incentive to protest.
Similarly, well-treated local employees may lobby against
expropriation.10 Local borrowing could help give local bankers
a stake in the health of the MNC's operations if any government
action threatened the affiliate's cash flows and thereby
jeopardized loan repayments.
Having local private investors as partners seems to provide
protection. One study found that joint ventures with local
partners have historically suffered only a 0.2% rate of
nationalization, presumably because this arrangement
establishes a powerful local voice with a vested interest in
opposing government seizure.11
The shield provided by local investors may be of limited value
to the MNC, however. The partners will be deemed to be tainted

by association with the multinational. A government probably
would not be deterred from expropriation or enacting
discriminatory laws because of the existence of local
shareholders. Moreover, the action can be directed solely
against the foreign investor, and the local partners can be the
genesis of a move to expropriate to enable them to acquire the
whole of a business at a low or no cost.
10 French workers at U.S.-owned plants, satisfied with their
employers’ treatment of them, generally stayed on the job
during the May 1968 student-worker riots in France, even
though most French firms were struck.
11 Bradley, “Managing Against Expropriation,” pp. 75–83.
Adaptation.
Today, some firms are trying a more radical approach to
political risk management. Their policy entails adapting to the
inevitability of potential expropriation and trying to earn profits
on the firm's resources by entering into licensing and
management agreements. For example, oil companies whose
properties were nationalized by the Venezuelan government
received management contracts to continue their exploration,
refining, and marketing operations. These firms have recognized
that it is not necessary to own or control an asset such as an oil
well to earn profits. This form of arrangement may be more
common in the future as countries develop greater management
abilities and decide to purchase from foreign firms only those
skills that remain in short supply at home. Firms that are unable
to surrender control of their foreign operations because these
operations are integrated into a worldwide production-planning
system or some other form of global strategy are also the least
likely to be troubled by the threat of property seizure, as was
CHAPTER 19 Current Asset Management and Short-Term
Financing
The management of working capital in the multinational

corporation is similar to its domestic counterpart. Both are
concerned with selecting that combination of current assets—
cash, marketable securities, accounts receivable, and
inventory—and current liabilities—short-term funds to finance
those current assets—that will maximize the value of the firm.
The essential differences between domestic and international
working-capital management include the impact of currency
fluctuations, potential exchange controls, and multiple tax
jurisdictions on these decisions, in addition to the wider range
of short-term financing and investment options available.
Chapter 20 discusses the mechanisms by which the
multinational firm can shift liquid assets among its various
affiliates; it also examines the tax and other consequences of
these maneuvers. This chapter deals with the management of
working-capital items available to each affiliate. The focus is
on international cash, accounts receivable, inventory
management, and short-term financing.
19.1 International Cash Management
International money managers attempt to attain on a worldwide
basis the traditional domestic objectives of cash management:
(1) bringing the company's cash resources within control as
quickly and efficiently as possible and (2) achieving the
optimum conservation and utilization of these funds.
Accomplishing the first goal requires establishing accurate,
timely forecasting and reporting systems, improving cash
collections and disbursements, and decreasing the cost of
moving funds among affiliates. The second objective is
achieved by minimizing the required level of cash balances,
making money available when and where it is needed, and
increasing the risk-adjusted return on those funds that can be
invested.
This section is divided into seven key areas of international
cash management: (1) organization, (2) collection and
disbursement of funds, (3) netting of interaffiliate payments, (4)
investment of excess funds, (5) establishment of an optimal
level of worldwide corporate cash balances, (6) cash planning

and budgeting, and (7) bank relations.
Organization
When compared with a system of autonomous operating units, a
fully centralized international cash management program offers
a number of advantages:
• The corporation is able to operate with a smaller amount of
cash, pools of excess liquidity are absorbed and eliminated, and
each operation will maintain transactions balances only and not
hold speculative or precautionary ones.
• By reducing total assets, profitability is enhanced and
financing costs are reduced.
• The headquarters staff, with its purview of all corporate
activity, can recognize problems and opportunities that an
individual unit might not perceive.
• All decisions can be made using the overall corporate
benefit as the criterion.
• By increasing the volume of foreign exchange and other
transactions done through headquarters, firms encourage banks
to provide better foreign exchange quotes and better service.
• Greater expertise in cash and portfolio management exists
if one group is responsible for these activities.
• Less can be lost in the event of an expropriation or
currency controls restricting the transfer of funds because the
corporation's total assets at risk in a foreign country can be
reduced.
Many experienced multinational firms have long understood
these benefits. Today, the combination of volatile currency and
interest rate fluctuations, questions of capital availability,
increasingly complex organizations and operating arrangements,
and a growing emphasis on profitability virtually mandates a
highly centralized international cash management system. There
is also a trend to place much greater responsibility in corporate
headquarters.
Centralization does not necessarily mean that corporate
headquarters has control of all facets of cash management.
Instead, a concentration of decision making at a sufficiently

high level within the corporation is required so that all pertinent
information is readily available and can be used to optimize the
firm's position.
Collection and Disbursement of Funds
Accelerating collections both within a foreign country and
across borders is a key element of international cash
management. Material potential benefits exist because long
delays often are encountered in collecting receivables,
particularly on export sales, and in transferring funds among
affiliates and corporate headquarters. Allowing for mail time
and bank processing, delays of eight to 10 business days are
common from the moment an importer pays an invoice to the
time when the exporter is credited with good funds—that is,
when the funds are available for use. Given high interest rates,
wide fluctuations in the foreign exchange markets, and the
periodic imposition of credit restrictions that have characterized
financial markets in some years, cash in transit has become
more expensive and more exposed to risk.
With increasing frequency, corporate management is
participating in the establishment of an affiliate's credit policy
and the monitoring of collection performance. The principal
goals of this intervention are to minimize float—that is, the
transit time of payments—to reduce the investment in accounts
receivable and to lower banking fees and other transaction
costs. By converting receivables into cash as rapidly as
possible, a company can increase its portfolio or reduce its
borrowing and thereby earn a higher investment return or save
interest expense.
Considering either national or international collections,
accelerating the receipt of funds usually involves (1) defining
and analyzing the different available payment channels; (2)
selecting the most efficient method, which can vary by country
and by customer; and (3) giving specific instructions regarding
procedures to the firm's customers and banks.
In addressing the first two points, the full costs of using the
various methods must be determined, and the inherent delay of

each must be calculated. Two main sources of delay in the
collections process are (1) the time between the dates of
payment and of receipt and (2) the time for the payment to clear
through the banking system. Inasmuch as banks will be as
“inefficient” as possible to increase their float, understanding
the subtleties of domestic and international money transfers is
requisite if a firm is to reduce the time that funds are held and
extract the maximum value from its banking relationships.
Exhibit 19.1 lists the different methods multinationals use to
expedite their collection of receivables.
With respect to payment instructions to customers and banks,
the use of cable remittances is a crucial means for companies to
minimize delays in receipt of payments and in conversion of
payments into cash, especially in Europe because European
banks tend to defer the value of good funds when the payment is
made by check or draft.
In the case of international cash movements, having all
affiliates transfer funds by telex enables the corporation to plan
better because the vagaries of mail time are eliminated. Third
parties, too, will be asked to use wire transfers. For most
amounts, the fees required for telex are less than the savings
generated by putting the money to use more quickly.
Exhibit 19.1 How Multinationals Expedite Their Collection of
Receivables
One of the cash manager's biggest problems is that bank-to-bank
wire transfers do not always operate with great efficiency or
reliability. Delays, crediting the wrong account, availability of
funds, and many other operational problems are common. One
solution to these problems is to be found in the SWIFT (Society
for Worldwide Interbank Financial Telecommunications)
network, first mentioned in Chapter 7. SWIFT has standardized
international message formats and employs a dedicated
computer network to support funds transfer messages.
The SWIFT network connects more than 7,000 banks and
broker-dealers in 192 countries and processes more than 5

million transactions a day, representing about $5 trillion in
payments. Its mission is to transmit standard forms quickly to
allow its member banks to process data automatically by
computer. All types of customer and bank transfers are
transmitted, as well as foreign exchange deals, bank account
statements, and administrative messages. To use SWIFT, the
corporate client must deal with domestic banks that are
subscribers and with foreign banks that are highly automated.
Like many other proprietary data networks, SWIFT is facing
growing competition from Internet-based systems that allow
both banks and nonfinancial companies to connect to a secure
payments network.
To cope with some of the transmittal delays associated with
checks or drafts, customers are instructed to remit to
“mobilization” points that are centrally located in regions with
large sales volumes. These funds are managed centrally or are
transmitted to the selling subsidiary. For example, European
customers may be told to make all payments to Switzerland,
where the corporation maintains a staff specializing in cash and
portfolio management and collections.
Sometimes customers are asked to pay directly into a designated
account at a branch of the bank that is mobilizing the MNC's
funds internationally. This method is particularly useful when
banks have large branch networks. Another technique used is to
have customers remit funds to a designated lock box, which is a
postal box in the company's name. One or more times daily, a
local bank opens the mail received at the lock box and deposits
any checks immediately.
Multinational banks now provide firms with rapid transfers of
their funds among branches in different countries, generally
giving their customers same-day value—that is, funds are
credited that same day. Rapid transfers also can be
accomplished through a bank's correspondent network, although
it becomes somewhat more difficult to arrange same-day value
for funds.
Chief financial officers increasingly rely on computers and

worldwide telecommunications networks to help manage their
company's cash portfolio. Many multinational firms will not
deal with a bank that does not have a leading-edge electronic
banking system.
At the heart of today's high-tech corporate treasuries are the
treasury workstation software packages that many big banks sell
as supplements to their cash management systems. Linking the
company with its bank and branch offices, the workstations let
treasury personnel compute a company's worldwide cash
position on a real-time basis. Thus, the second a transaction is
made in, say, Rio de Janeiro, it is electronically recorded in
Tokyo as well. This simultaneous record keeping lets companies
keep their funds active at all times. Treasury personnel can use
their workstations to initiate fund transfers from units with
surplus cash to those units that require funds, thereby reducing
the level of bank borrowings.
APPLICATION International Cash Management at National
Semiconductor
After computerizing its cash management system, National
Semiconductor was able to save significant interest expenses by
transferring money quickly from locations with surplus cash to
those needing money. In a typical transaction, the company
shifted a surplus $500,000 from its Japanese account to its
Philippine operations—avoiding the need to borrow the half-
million dollars and saving several thousand dollars in interest
expense. Before computerization, it would have taken five or
six days to discover the surplus.
Management of disbursements is a delicate balancing act:
holding onto funds versus staying on good terms with suppliers.
It requires a detailed knowledge of individual country and
supplier nuances, as well as the myriad payment instruments
and banking services available around the world. Exhibit 19.2
presents some questions that corporate treasurers should address
in reviewing their disbursement policies.
Payments Netting in International Cash Management
Many multinational corporations are now in the process of

rationalizing their production on a global basis. This process
involves a highly coordinated international interchange of
materials, parts, subassemblies, and finished products among
the various units of the MNC, with many affiliates both buying
from and selling to each other.
The importance of these physical flows to the international
financial executive is that they are accompanied by a heavy
volume of interaffiliate fund flows. Of particular importance is
the fact that a measurable cost is associated with these cross-
border fund transfers, including the cost of purchasing foreign
exchange (the foreign exchange spread); the opportunity cost of
float (time in transit); and other transaction costs, such as cable
charges. These transaction costs are estimated to vary from
0.25% to 1.5% of the volume transferred. Thus, there is a clear
incentive to minimize the total volume of intercompany fund
flows. This can be achieved by payments netting.
Exhibit 19.2 Reviewing Disbursements: Auditing Payment
Instruments
Bilateral and Multilateral Netting.
The idea behind a payments netting system is simple: Payments
among affiliates go back and forth, whereas only a netted
amount need be transferred. Suppose, for example, the German
subsidiary of an MNC sells goods worth $1 million to its Italian
affiliate that in turn sells goods worth $2 million to the German
unit. The combined flows total $3 million. On a net basis,
however, the German unit need remit only $1 million to the
Italian unit. This type of bilateral netting is valuable, however,
only if subsidiaries sell back and forth to each other.
Bilateral netting would be of less use when there is a more
complex structure of internal sales, such as in the situation
depicted in Exhibit 19.3a, which presents the payment flows
(converted first into a common currency, assumed here to be the
dollar) that take place among four European affiliates, located
in France, Belgium, Sweden, and the Netherlands. On a
multilateral basis, however, there is greater scope for reducing

cross-border fund transfers by netting out each affiliate's
inflows against its outflows.
Since a large percentage of multinational transactions are
internal, leading to a relatively large volume of interaffiliate
payments, the payoff from multilateral netting can be large
relative to the costs of such a system. Many companies find
they can eliminate 50% or more of their intercompany
transactions through multilateral netting, with annual savings in
foreign exchange transactions costs and bank-transfer charges
that average between 0.5% and 1.5% per dollar netted. For
example, SmithKline Beckman (now part of GlaxoSmithKline)
estimated that it saved $300,000 annually in foreign exchange
transactions costs and bank transfer charges by using a
multilateral netting system.1 Similarly, Baxter International
estimated that it saved $200,000 per year by eliminating
approximately 60% of its intercompany transactions through
netting.2
Exhibit 19.3A payment Flows before multilateral netting
Exhibit 19.3B intercompany Payments Matrix (u.s.$ Millions)
1 “How Centralized Systems Benefit Managerial Control:
SmithKline Beckman,” Business International Money Report,
June 23, 1986, p. 198.
2 Business International Corporation, Solving International
Financial and Currency Problems (New York: BIC, 1976), p. 29.
Information Requirements.
Essential to any netting scheme is a centralized control point
that can collect and record detailed information on the
intracorporate accounts of each participating affiliate at
specified time intervals. The control point, called a netting
center, is a subsidiary company set up in a location with
minimal exchange controls for trade transactions.
The netting center will use a matrix of payables and receivables
to determine the net payer or creditor position of each affiliate
at the date of clearing. An example of such a matrix is provided

in Exhibit 19.3b, which takes the payment flows from Exhibit
19.3a and shows the amounts due to and from each of the
affiliated companies. Note that in an intercompany system, the
payables will always equal the receivables on both a gross basis
and a net basis. Typically, the impact of currency changes on
the amounts scheduled for transfer is minimized by fixing the
exchange rate at which these transactions occur during the week
that netting takes place.
Without netting, the total payments in the system would equal
$44 million and the number of separate payments made would
be 11. Multilateral netting will pare these transfers to $12
million, a net reduction of 73%, and the number of payments
can be reduced to three, a net reduction of 73% as well. One
possible set of payments is shown in Exhibit 19.3c. Assuming
foreign exchange and bank-transfer charges of 0.75%, this
company will save $240,000 through netting (0.0075 × $32
million).
Notice that alternative sets of multilateral payments were also
possible in this example. The Swedish unit could have paid $11
million to the Dutch unit, with the Dutch and Belgian units then
sending $1 million each to the French unit. The choice of which
affiliate(s) each payer pays depends on the relative costs of
transferring funds between each pair of affiliates. The per-unit
costs of sending funds between two affiliates can vary
significantly from month to month because one subsidiary may
receive payment from a third party in a currency that the other
subsidiary needs. Using this currency for payment can eliminate
one or more foreign exchange conversions. This conclusion
implies that the cost of sending funds from Germany to France,
for example, can differ greatly from the cost of moving money
from France to Germany.
For example, Volvo has a policy of transferring a currency,
without conversion, to a unit needing that currency to pay a
creditor.3 To see how this policy works, suppose that Volvo
Sweden buys automotive components from a German
manufacturer and Volvo Belgium purchases automotive kits

from Volvo Sweden. At the same time, a German dealer buys
automobiles from Volvo Belgium and pays in euros. Volvo
Belgium will then use these euros to pay Volvo Sweden, which
in turn will use them to pay its German creditor.
Exhibit 19.3C payment flows after multilateral netting
3 Ibid., p. 32.
Foreign Exchange Controls
Before implementing a payments netting system, a company
needs to know whether any restrictions on netting exist. Firms
sometimes may be barred from netting or be required to obtain
permission from the local monetary authorities.
Analysis
The higher the volume of intercompany transactions and the
more back-and-forth selling that takes place, the more
worthwhile netting is likely to be. A useful approach to
evaluating a netting system would be to establish the direct cost
savings of the netting system and then use this figure as a
benchmark against which to measure the costs of
implementation and operation. These setup costs have been
estimated at less than $20,000.4
An additional benefit from running a netting system is the
tighter control that management can exert over corporate fund
flows. The same information required to operate a netting
system also will enable an MNC to shift funds in response to
expectations of currency movements, changing interest
differentials, and tax differentials.
APPLICATION Cost/Benefit Analysis of an International
Cash Management System
Although company A already operates a multilateral netting
system, it commissioned a study to show where additional
improvements in cash management could be made.5 The firm
proposed to establish a finance company (FINCO) in Europe.
FINCO's primary function would be to act as a collecting and
paying agent for divisions of company A that export to third
parties. All receivables would be gathered into the international

branch network of bank X. Each branch would handle
receivables denominated in the currency of its country of
domicile. These branch accounts would be monitored by both
FINCO and the exporting unit via the bank's electronic
reporting facility.
Intercompany payments and third-party collection payments
from FINCO to each exporter would be included in the existing
multilateral netting system, which would be administered by
FINCO. Payments for imports from third-party suppliers also
would be included. Finally, the netting system would be
expanded to include intercompany payments from operations in
the United States, Canada, and one additional European country.
The feasibility study examined six basic savings components
and two cost components. The realizable, annualized savings are
summarized as follows:
Savings Component
Cost Savings
1. Optimized multilateral netting
$ 29,000
2. Reduced remittance-processing time by customer and
remitting bank
26,000
3. Reduction in cross-border transfer float by collecting
currencies in their home country
46,000
4. Reduction in cross-border transfer commissions and charges
by collecting currencies in their home country
41,000
5. Use of incoming foreign currencies to source outgoing
foreign payments in the same currencies
16,000
6. Use of interest-bearing accounts
8,000
Total estimated annual savings
$166,000
Cost Component

Cost
1. Computer time-sharing charges for accessing bank X's system
$ 17,000
2. Communications charges for additional cross-border funds
transfers
13,000
Total estimated annual costs
$ 30,000
Total net savings
$136,000
4 Business International Corporation, “The State of the Art,”
in New Techniques in International Exposure and Cash
Management, vol. 1 (New York: BIC, 1977), p. 244.
5 This illustration appears in “Cost/Benefit Analysis of One
Company's Cash Management System,” Business International
Money Report, April 14, 1986, pp. 119–120.
Management of the Short-Term Investment Portfolio
A major task of international cash management is to determine
the levels and currency denominations of the multinational
group's investment in cash balances and money market
instruments. Firms with seasonal or cyclical cash flows have
special problems, such as spacing investment maturities to
coincide with projected needs. To manage this investment
properly requires (1) a forecast of future cash needs based on
the company's current budget and past experience and (2) an
estimate of a minimum cash position for the coming period.
These projections should take into account the effects of
inflation and anticipated currency changes on future cash flows.
Successful management of an MNC's required cash balances and
of any excess funds generated by the firm and its affiliates
depends largely on the astute selection of appropriate short-term
money market instruments. Rewarding opportunities exist in
many countries, but the choice of an investment medium
depends on government regulations, the structure of the market,
and the tax laws, all of which vary widely. Available money
instruments differ among the major markets, and at times,

foreign firms are denied access to existing investment
opportunities. Only a few markets, such as the broad and
diversified U.S. market and the Eurocurrency markets, are truly
free and international. Capsule summaries of key money market
instruments are provided in Exhibit 19.4.
Once corporate headquarters has fully identified the present and
future needs of its affiliates, it must then decide on a policy for
managing its liquid assets worldwide. This policy must
recognize that the value of shifting funds across national
borders to earn the highest possible risk-adjusted return depends
not only on the risk-adjusted yield differential, but also on the
transaction costs involved. In fact, the basic reason for holding
cash in several currencies simultaneously is the existence of
currency conversion costs. If these costs are zero and
government regulations permit, all cash balances should be held
in the currency having the highest effective risk-adjusted return
net of withdrawal costs.
Given that transaction costs do exist, the appropriate currency
denomination mix of an MNC's investment in money and near-
money assets is probably more a function of the currencies in
which it has actual and projected inflows and outflows than of
effective yield differentials or government regulations. The
reason is simple: Despite government controls, it would be
highly unusual to see an annualized risk-adjusted interest
differential of even 2%. Although seemingly large, a 2% annual
differential yields only an additional 0.167% for a 30-day
investment or 0.5% extra for a 90-day investment. Such small
differentials can easily be offset by foreign exchange
transaction costs. Thus, even large annualized risk-adjusted
interest spreads may not justify shifting funds for short-term
placements.
Portfolio Guidelines
Common-sense guidelines for globally managing the marketable
securities portfolio are as follows:
1. Diversify the instruments in the portfolio to maximize the
yield for a given level of risk. Don't invest only in government

securities. Eurodollar and other instruments may be nearly as
safe.
2. Review the portfolio daily to decide which securities
should be liquidated and which new investments should be
made.
3. In revising the portfolio, make sure that the incremental
interest earned more than compensates for added costs such as
clerical work, the income lost between investments, fixed
charges such as the foreign exchange spread, and commissions
on the sale and purchase of securities.
Exhibit 19.4 key money market instruments
4. If rapid conversion to cash is an important consideration,
then carefully evaluate the security's marketability (liquidity).
Ready markets exist for some securities, but not for others.
5. Tailor the maturity of the investment to the firm's
projected cash needs, or be sure a secondary market for the
investment with high liquidity exists.
6. Carefully consider opportunities for covered or uncovered
interest arbitrage.
Optimal Worldwide Cash Levels
Centralized cash management typically involves the transfer of
an affiliate's cash in excess of minimal operating requirements
into a centrally managed account, or cash pool. Some firms have
established a special corporate entity that collects and disburses
funds through a single bank account.
With cash pooling, each affiliate need hold locally only the
minimum cash balance required for transactions purposes. All
precautionary balances are held by the parent or in the pool. As
long as the demands for cash by the various units are reasonably
independent of one another, centralized cash management can
provide an equivalent degree of protection with a lower level of
cash reserves.
Another benefit from pooling is that either less borrowing needs
be done or more excess funds are available for investment that
will maximize returns. Consequently, interest expenses are

reduced or investment income is increased. In addition, the
larger the pool of funds, the more worthwhile it becomes for a
firm to invest in cash management expertise. Furthermore,
pooling permits exposure arising from holding foreign currency
cash balances to be centrally managed.
Evaluation and Control
Taking over control of an affiliate's cash reserves can create
motivational problems for local managers unless some
adjustments are made to the way in which these managers are
evaluated. One possible approach is to relieve local managers of
profit responsibility for their excess funds. The problem with
this solution is that it provides no incentive for local managers
to take advantage of specific opportunities of which only they
may be aware.
An alternative approach is to present local managers with
interest rates for borrowing or lending funds to the pool that
reflect the opportunity cost of money to the parent corporation.
In setting these internal interest rates (IIRs), the corporate
treasurer, in effect, is acting as a bank, offering to borrow or
lend currencies at given rates. By examining these IIRs, local
treasurers will be more aware of the opportunity cost of their
idle cash balances, as well as having an added incentive to act
on this information. In many instances, they will prefer to
transfer at least part of their cash balances (where permitted) to
a central pool in order to earn a greater return. To make pooling
work, managers must have access to the central pool whenever
they require money.
APPLICATION An Italian Cash Management System
An Italian firm has created a centralized cash management
system for its 140 operating units within Italy. At the center is a
holding company that manages banking relations, borrowings,
and investments. In the words of the firm's treasurer, “We put
ourselves in front of the companies as a real bank and say, ‘If
you have a surplus to place, I will pay you the best rates.’ If the
company finds something better than that, they are free to place
the funds outside the group. But this doesn't happen very

often.”6 In this way, the company avoids being overdrawn with
one bank while investing with another.
6 “Central Cash Management Step by Step: The European
Approach,” Business International Money Report, October 19,
1984, p. 331.
Cash Planning and Budgeting
The key to the successful global coordination of a firm's cash
and marketable securities is a good reporting system. Cash
receipts must be reported and forecast in a comprehensive,
accurate, and timely manner. If the headquarters staff is to use
the company's worldwide cash resources fully and
economically, they must know the financial positions of
affiliates, the forecast cash needs or surpluses, the anticipated
cash inflows and outflows, local and international money
market conditions, and likely currency movements.
As a result of rapid and pronounced changes in the international
monetary arena, the need for more frequent reports has become
acute. Firms that had been content to receive information
quarterly now require monthly, weekly, or even daily data. Key
figures are often transmitted by e-mail or via a corporate
intranet.
Multinational Cash Mobilization
A multinational cash mobilization system is designed to
optimize the use of funds by tracking current and near-term
cash positions. The information gathered can be used to aid a
multilateral netting system, to increase the operational
efficiency of a centralized cash pool, and to determine more
effective short-term borrowing and investment policies.
The operation of a multinational cash mobilization system is
illustrated here with a simple example centered on a firm's four
European affiliates. Assume that the European headquarters
maintains a regional cash pool in London for its operating units
located in England, France, Germany, and Italy. Each day, at
the close of banking hours, every affiliate reports to London its
current cash balances in cleared funds—that is, its cash
accounts net of all receipts and disbursements that have cleared

during the day. All balances are reported in a common currency,
which is assumed here to be the U.S. dollar, with local
currencies translated at rates designated by the manager of the
central pool.
One report format is presented in Exhibit 19.5. It contains the
end-of-day balance as well as a revised five-day forecast.
According to the report for July 12, the Italian affiliate has a
cash balance of $400,000. This balance means the affiliate
could have disbursed an additional $400,000 that day without
creating a cash deficit or having to use its overdraft facilities.
The French affiliate, on the other hand, has a negative cash
balance of $150,000, which it is presumably covering with an
overdraft. Alternatively, it might have borrowed funds from the
pool to cover this deficit. The British and German subsidiaries
report cash surpluses of $100,000 and $350,000, respectively.
The manager of the central pool can then assemble these
individual reports into a more usable form, such as that depicted
in Exhibit 19.6. This report shows the cash balance for each
affiliate, its required minimum operating cash balance, and the
resultant cash surplus or deficit for each affiliate individually
and for the region as a whole. According to the report, both the
German and Italian affiliates ended the day with funds in excess
of their operating needs, whereas the English unit wound up
with $25,000 less than it normally requires in operating funds
(even though it had $100,000 in cash). The French affiliate was
short $250,000, including its operating deficit and minimum
required balances. For the European region as a whole,
however, there was excess cash of $75,000.
Exhibit 19.5 Daily Cash reports of European central Cash
Pool (U.s. $ Thousands)
The information contained in these reports can be used to
decide how to cover any deficits and where to invest temporary
surplus funds. Netting also can be facilitated by breaking down
each affiliate's aggregate inflows and outflows into their
individual currency components. This breakdown will aid in

deciding which netting operations to perform and in which
currencies.
Exhibit 19.6 Aggregate Cash Position of European Central
Cash Pool (U.s. $ Thousands)
The cash forecasts contained in the daily reports can help
determine when to transfer funds to or from the central pool and
the maturities of any borrowings or investments. For example,
although the Italian subsidiary currently has $250,000 in excess
funds, it projects a deficit tomorrow of $100,000. One possible
strategy is to have the Italian unit remit $250,000 to the pool
today and, in turn, have the pool return $100,000 tomorrow to
cover the projected deficit. However, unless interest
differentials are large and/or transaction costs are minimal, it
may be preferable to instruct the Italian unit to remit only
$150,000 to the pool and invest the remaining $100,000
overnight in Italy.
Similarly, the five-day forecast shown in Exhibit 19.7, based on
the data provided in Exhibit 19.6, indicates that the $75,000
European regional surplus generated today can be invested for
at least two days before it is required (because of the cash
deficit forecasted two days from today).
The cash mobilization system illustrated here has been greatly
simplified in order to bring out some key details. In reality,
such a system should include longer-term forecasts of cash
flows broken down by currency, forecasts of intercompany
transactions (for netting purposes), and interest rates paid by
the pool (for decentralized decision making).
Bank Relations
Good bank relations are central to a company's international
cash management effort. Although some companies may be
quite pleased with their banks’ services, others may not even
realize that they are being poorly served by their banks. Poor
cash management services mean lost interest revenues,
overpriced services, and inappropriate or redundant services.
Here are some common problems in bank relations:

• Too many relations: Many firms that have conducted a
bank relations audit find that they are dealing with too many
banks. Using too many banks can be expensive. It also
invariably generates idle balances, higher compensating
balances, more checkclearing float, suboptimal rates on foreign
exchange and loans, a heavier administrative workload, and
diminished control over every aspect of banking relations.
Exhibit 19.7 Five-Day Cash Forecast of European Central
Cash Pool (U.S. $ Thousands)
• High banking costs: To keep a lid on bank expenses,
treasury management must carefully track not only the direct
costs of banking services—including rates, spreads, and
commissions—but also the indirect costs rising from check
float, value-dating—that is, when value is given for funds—and
compensating balances. This monitoring is especially important
in the developing countries of Latin America and Asia. In these
countries, compensating balance requirements—the fraction of
an outstanding loan balance required to be held on deposit in a
non-interest-bearing account—may range as high as 30% to
35%, and check-clearing times may drag on for days or even
weeks. It also pays off in European countries such as Italy,
where banks enjoy value-dating periods of as long as 20 to 25
days.
• Inadequate reporting: Banks often do not provide
immediate information on collections and account balances.
This delay can cause excessive amounts of idle cash and
prolonged float. To avoid such problems, firms should instruct
their banks to provide daily balance information and to
distinguish clearly between ledger and collected balances—that
is, posted totals versus immediately available funds.
• Excessive clearing delays: In many countries, bank float
can rob firms of funds availability. In nations such as Mexico,
Spain, Italy, and Indonesia, checks drawn on banks located in
remote areas can take weeks to clear to headquarters accounts in
the capital city. Fortunately, firms that negotiate for better float

times often meet with success. Whatever method is used to
reduce clearing time, it is crucial that companies constantly
check up on their banks to ensure that funds are credited to
accounts as expected.
Negotiating better service is easier if the company is a valued
customer. Demonstrating that it is a valuable customer requires
the firm to have ongoing discussions with its bankers to
determine the precise value of each type of banking activity and
the value of the business it generates for each bank. Armed with
this information, the firm should make up a monthly report that
details the value of its banking business. By compiling this
report, the company knows precisely how much business it is
giving to each bank it uses. With such information in hand, the
firm can negotiate better terms and better service from its
banks.
APPLICATION How Morton Thiokol Manages Its Bank
Relations
Morton Thiokol, a Chicago-based manufacturer with
international sales of about $300 million, centralizes its banking
policy for three main reasons: Cash management is already
centralized; small local staffs may not have time to devote to
bank relations; and overseas staffs often need the extra guidance
of centralized bank relations. Morton Thiokol is committed to
trimming its overseas banking relations to cut costs and
streamline cash management. A key factor in maintaining
relations with a bank is the bank's willingness to provide the
firm with needed services at reasonable prices. Although
Morton Thiokol usually tries to reduce the number of banks
with which it maintains relations, it will sometimes add banks
to increase competition and thereby improve its chances of
getting quality services and reasonable prices.
19.2 Accounts Receivable Management
Firms grant trade credit to customers, both domestically and
internationally, because they expect the investment in
receivables to be profitable, either by expanding sales volume
or by retaining sales that otherwise would be lost to

competitor's. Some companies also earn a profit on the
financing charges they levy on credit sales.
The need to scrutinize credit terms is particularly important in
countries experiencing rapid rates of inflation. The incentive for
customers to defer payment, liquidating their debts with less
valuable money in the future, is great. Furthermore, credit
standards abroad are often more relaxed than standards in the
home market, especially in countries lacking alternative sources
of credit for small customers. To remain competitive, MNCs
may feel compelled to loosen their own credit standards.
Finally, the compensation system in many companies tends to
reward higher sales more than it penalizes an increased
investment in accounts receivable. Local managers frequently
have an incentive to expand sales even if the MNC overall does
not benefit.
The effort to better manage receivables overseas will not get far
if finance and marketing do not coordinate their efforts. In
many companies, finance and marketing work at cross purposes.
Marketing thinks about selling, and finance thinks about
speeding up cash flows. One way to ease the tensions between
finance and marketing is to educate the sales force on how
credit and collection affect company profits. Another way is to
tie bonuses for salespeople to collected sales or to adjust sales
bonuses for the interest cost of credit sales. Forcing managers
to bear the opportunity cost of working capital ensures that their
credit, inventory, and other working-capital decisions will be
more economical.
APPLICATION Nestlé Charges for Working Capital
Nestlé charges local subsidiary managers for the interest
expense of networking capital using an internally devised
standard rate. The inclusion of this finance charge encourages
country managers to keep a tight rein on accounts receivable
and inventory because the lower the net working capital, the
lower the theoretical interest charge, and the higher their
profits.
Credit Extension

A firm selling abroad faces two key credit decisions: the
amount of credit to extend and the currency in which credit
sales are to be billed. Nothing need be added here to the
discussion in Chapter 10 (p. 374) of the latter decision except to
note that competitor's will often resolve the currency-of-
denomination issue.
The easier the credit terms are, the more sales are likely to be
made. But generosity is not always the best policy. Balanced
against higher revenues must be the risk of default, increased
interest expense on the larger investment in receivables, and the
deterioration (through currency devaluation) of the dollar value
of accounts receivable denominated in the buyer's currency.
These additional costs may be partly offset if liberalized credit
terms enhance a firm's ability to raise its prices.
The bias of most personnel evaluation systems is in favor of
higher revenues, but another factor often tends to increase
accounts receivable in foreign countries. An uneconomic
expansion of local sales may occur if managers are credited
with dollar sales when accounts receivable are denominated in
the local currency. Sales managers should be charged for the
expected depreciation in the value of local currency accounts
receivable. For instance, if the current exchange rate is LC 1 =
$0.10, but the expected exchange rate 90 days hence (or the
three-month forward rate) is $0.09, managers providing three-
month credit terms should be credited with only $0.90 for each
dollar in sales booked at the current spot rate.
The following five-step approach enables a firm to compare the
expected benefits and costs associated with extending credit
internationally:
1. Calculate the current cost of extending credit.
2. Calculate the cost of extending credit under the revised
credit policy.
3. Using the information from steps 1 and 2, calculate
incremental credit costs under the revised credit policy.
4. Ignoring credit costs, calculate incremental profits under
the new credit policy.

5. If, and only if, incremental profits exceed incremental
credit costs, select the new credit policy.
APPLICATION Evaluating Credit Extension Overseas
Suppose a subsidiary in France currently has annual sales of $1
million with 90-day credit terms. It is believed that sales will
increase by 6%, or $60,000, if terms are extended to 120 days.
Of these additional sales, the cost of goods sold is $35,000.
Monthly credit expenses are 1% in financing charges. In
addition, the euro is expected to depreciate an average of 0.5%
every 30 days.
If we ignore currency changes for the moment, but consider
financing costs, the value today of $1 of receivables to be
collected at the end of 90 days is approximately $0.97. When
the expected euro depreciation of 1.5% (3 × 0.5%) over the 90-
day period is taken into account, this value declines to 0.97(1 −
0.015), or $0.955, implying a 4.5% cost of carrying euro
receivables for three months. Similarly, $1 of receivables
collected 120 days from now is worth (1 − 4 × 0.01)(1 − 0.02)
today, or $0.941. Then the incremental cost of carrying euro
receivables for the fourth month equals 0.955 − 0.941 dollars,
or 1.4%.
Applying the five-step evaluation approach and using the
information generated in this application yields current 90-day
credit costs of $1,000,000 × 0.045 = $45,000. Lengthening the
terms to 120 days will raise this cost to $1,000,000 × 0.059 =
$59,000. The cost of carrying for 120 days the incremental sales
of $60,000 is $60,000 × 0.059 = $3,540. Thus, incremental
credit costs under the new policy equal $59,000 + $3,540 −
$45,000 = $17,540. Since this amount is less than the
incremental profit of $25,000 (60,000 − 35,000), it is
worthwhile to provide a fourth month of credit.
19.3 Inventory Management
Inventory in the form of raw materials, work in process, or
finished goods is held (1) to facilitate the production process by
both ensuring that supplies are at hand when needed and
allowing a more even rate of production and (2) to make certain

that goods are available for delivery at the time of sale.
Although, conceptually, the inventory management problems
faced by multinational firms are not unique, they may be
exaggerated in the case of foreign operations. For instance,
MNCs typically find it more difficult to control their inventory
and realize inventory turnover objectives in their overseas
operations than in their domestic ones. There are a variety of
reasons: long and variable transit times if ocean transportation
is used, lengthy customs proceedings, dock strikes, import
controls, high duties, supply disruption, and anticipated changes
in currency values.
Production Location and Inventory Control
Many U.S. companies have eschewed domestic manufacturing
for offshore production to take advantage of low-wage labor and
a grab bag of tax holidays, low-interest loans, and other
government largess. However, a number of firms have found
that low manufacturing cost is not everything. Aside from the
strategic advantages associated with U.S. production, such as
maintaining close contact with domestic customers, onshore
manufacturing allows for a more efficient use of capital. In
particular, because of the delays in international shipment of
goods and potential supply disruptions, firms producing abroad
typically hold larger work-in-process and finished goods
inventories than do domestic firms. The result is higher
inventory-carrying costs.
APPLICATION Cypress Semiconductor Decides to Stay
Onshore
The added inventory expenses that foreign manufacture would
entail are an important reason that Cypress Semiconductor
decided to manufacture integrated circuits in San Jose,
California, instead of going abroad. Cypress makes relatively
expensive circuits (they average around $8 apiece), so time-
consuming international shipments would have tied up the
company's capital in an expensive way. Even though offshore
production would save about $0.032 per chip in labor costs, the
company estimated that the labor saving would be more than

offset by combined shipping and customs duties of $0.025 and
an additional $0.16 in the capital cost of holding inventory.
According to Cypress Chairman L. J. Sevin, “Some people just
look at the labor rates, but it's inventory cost that matters. It's
simply cheaper to sell a part in one week than in five or six.
You have to figure out what you could have done with the
inventory or the money you could have made simply by pulling
the interest on the dollars you have tied up in the part.”7
The estimate of $0.16 in carrying cost can be backed out as
follows: As the preceding quotation indicates, parts
manufactured abroad were expected to spend an extra five
weeks or so in transit. This means that parts manufactured
abroad would spend five more weeks in work-in-process
inventory than would parts manufactured domestically.
Assuming an opportunity cost of 20% (not an unreasonable
number considering the volatility of the semiconductor market)
and an average cost per chip of $8 yields the following added
inventory-related interest expense associated with overseas
production:
7 Joel Kotkin, “The Case for Manufacturing in America,”
Inc., March 1985, p. 54.
Advance Inventory Purchases
In many developing countries, forward contracts for foreign
currency are limited in availability or are nonexistent. In
addition, restrictions often preclude free remittances, making it
difficult, if not impossible, to convert excess funds into a hard
currency. One means of hedging is to engage in anticipatory
purchases of goods, especially imported items. The trade-off
involves owning goods for which local currency prices may be
increased, thereby maintaining the dollar value of the asset even
if devaluation occurs, versus forgoing the return on local money
market investments.
Inventory Stockpiling
Because of long delivery lead times, the often limited
availability of transport for economically sized shipments, and

currency restrictions, the problem of supply failure is of
particular importance for any firm that is dependent on foreign
sources. These conditions may make the knowledge and
execution of an optimal stocking policy, under a threat of a
disruption to supply, more critical in the MNC than in the firm
that purchases domestically.
The traditional response to such risks has been advance
purchases. Holding large amounts of inventory can be quite
expensive, however. The high cost of inventory stockpiling—
including financing, insurance, storage, and obsolescence—has
led many companies to identify low inventories with effective
management. In contrast, production and sales managers
typically desire a relatively large inventory, particularly when a
cutoff in supply is anticipated. One way to get managers to
consider the trade-offs involved—the costs of stockpiling versus
the costs of shortages—is to adjust the profit performances of
those managers who are receiving the benefits of additional
inventory on hand to reflect the added costs of stockpiling.
As the probability of disruption increases or as holding costs go
down, more inventory should be ordered. Similarly, if the cost
of a stock-out rises or if future supplies are expected to be more
expensive, it will pay to stockpile additional inventory.
Conversely, if these parameters were to move in the opposite
direction, less inventory should be stockpiled.
19.4 Short-Term Financing
Financing the working capital requirements of a multinational
corporation's foreign affiliates poses a complex decision
problem. This complexity stems from the large number of
financing options available to the subsidiary of an MNC.
Subsidiaries have access to funds from sister affiliates and the
parent, as well as from external sources. This section is
concerned with the following four aspects of developing a
short-term overseas financing strategy: (1) identifying the key
factors, (2) formulating and evaluating objectives, (3)
describing available short-term borrowing options, and (4)
developing a methodology for calculating and comparing the

effective dollar costs of these alternatives.
Key Factors in Short-Term Financing Strategy
Expected costs and risks, the basic determinants of any funding
strategy, are strongly influenced in an international context by
six key factors.
1. If forward contracts are unavailable, the crucial issue is
whether differences in nominal interest rates among currencies
are matched by anticipated changes in the exchange rate. For
example, is the difference between an 8% dollar interest rate
and a 3% Swiss franc interest rate due solely to expectations
that the dollar will devalue by 5% relative to the franc? The key
issue here, in other words, is whether there are deviations from
the international Fisher effect. If deviations do exist, then
expected dollar borrowing costs will vary by currency, leading
to a decision problem. Trade-offs must be made between the
expected borrowing costs and the exchange risks associated
with each financing option.
2. The element of exchange risk is the second key factor.
Many firms borrow locally to provide an offsetting liability for
their exposed local currency assets. On the other hand,
borrowing a foreign currency in which the firm has no exposure
will increase its exchange risk. That is, the risks associated with
borrowing in a specific currency are related to the firm's degree
of exposure in that currency.
3. The third essential element is the firm's degree of risk
aversion. The more risk averse the firm (or its management) is,
the higher the price it should be willing to pay to reduce its
currency exposure. Risk aversion affects the company's risk-
cost trade-off and consequently, in the absence of forward
contracts, influences the selection of currencies it will use to
finance its foreign operations.
4. If forward contracts are available, however, currency risk
should not be a factor in the firm's borrowing strategy. Instead,
relative borrowing costs, calculated on a covered basis, become
the sole determinant of which currencies to borrow in. The key
issue here is whether the nominal interest differential equals the

forward differential—that is, whether interest rate parity holds.
If it does hold, then the currency denomination of the firm's
debt is irrelevant. Covered costs can differ among currencies
because of government capital controls or the threat of such
controls. Because of this added element of risk, the annualized
forward discount or premium may not offset the difference
between the interest rate on the LC loan versus the dollar loan—
that is, interest rate parity will not hold.
5. Even if interest rate parity does hold before tax, the
currency denomination of corporate borrowings does matter
when tax asymmetries are present. These tax asymmetries are
based on the differential treatment of foreign exchange gains
and losses on either forward contracts or loan repayments. For
example, English firms or affiliates have a disincentive to
borrow in strong currencies because Inland Revenue, the British
tax agency, taxes exchange gains on foreign currency
borrowings but disallows the deductibility of exchange losses
on the same loans. An opposite incentive (to borrow in stronger
currencies) is created in countries such as Australia that may
permit exchange gains on forward contracts to be taxed at a
lower rate than the rate at which forward contract losses are
deductible. In such a case, even if interest parity holds before
tax, after-tax forward contract gains may be greater than after-
tax interest costs. Such tax asymmetries lead to possibilities of
borrowing arbitrage, even if interest rate parity holds before
tax. The essential point is that in comparing relative borrowing
costs, firms must compute these costs on an after-tax covered
basis.
6. A final factor that may enter into the borrowing decision is
political risk. Even if local financing is not the minimum cost
option, multinationals often will still try to maximize their local
borrowings if they believe that expropriation or exchange
controls are serious possibilities. If either event occurs, an
MNC has fewer assets at risk if it has used local, rather than
external, financing.
Short-Term Financing Objectives

Four possible objectives can guide a firm in deciding where and
in which currencies to borrow.
1.Minimize expected cost. By ignoring risk, this objective
reduces information requirements, allows borrowing options to
be evaluated on an individual basis without considering the
correlation between loan cash flows and operating cash flows,
and lends itself readily to break-even analysis (see Section 14.4,
p. 526).
2.Minimize risk without regard to cost. A firm that followed
this advice to its logical conclusion would dispose of all its
assets and invest the proceeds in government securities. In other
words, this objective is impractical and contrary to shareholder
interests.
3.Trade off expected cost and systematic risk. The advantage of
this objective is that, like the first objective, it allows a
company to evaluate different loans without considering the
relationship between loan cash flows and operating cash flows
from operations. Moreover, it is consistent with shareholder
preferences as described by the capital asset pricing model. In
practical terms, however, there is probably little difference
between expected borrowing costs adjusted for systematic risk
and expected borrowing costs without that adjustment. The
reason for this lack of difference is that the correlation between
currency fluctuations and a well-diversified portfolio of risky
assets is likely to be quite small.
4.Trade off expected cost and total risk. The theoretical
rationale for this approach was described in Chapter 1.
Basically, it relies on the existence of potentially substantial
costs of financial distress. On a more practical level,
management generally prefers greater stability of cash flows
(regardless of investor preferences). Management typically will
self-insure against most losses but might decide to use the
financial markets to hedge against the risk of large losses. To
implement this approach, it is necessary to take into account the
covariances between operating and financing cash flows. This
approach (trading off expected cost and total risk) is valid only

when forward contracts are unavailable. Otherwise, selecting
the lowest-cost borrowing option, calculated on a covered after-
tax basis, is the only justifiable objective (for the reason why,
see Section 10.4, p. 362).8
8 These possible objectives are suggested by Donald R.
Lessard, “Currency and Tax Considerations in International
Financing,” Teaching Note No. 3, Massachusetts Institute of
Technology, Spring 1979.
Short-Term Financing Options
Firms typically prefer to finance the temporary component of
current assets with short-term funds. The three principal short-
term financing options that may be available to an MNC include
(1) the intercompany loan, (2) the local currency loan, and (3)
commercial paper.
Intercompany Financing
A frequent means of affiliate financing is to have either the
parent company or sister affiliate provide an intercompany loan.
At times, however, these loans may be limited in amount or
duration by official exchange controls. In addition, interest
rates on intercompany loans are frequently required to fall
within set limits. The relevant parameters in establishing the
cost of such a loan include the lender's opportunity cost of
funds, the interest rate set, tax rates and regulations, the
currency of denomination of the loan, and expected exchange
rate movements over the term of the loan.
Local Currency Financing
Like most domestic firms, affiliates of multinational
corporations generally attempt to finance their working capital
requirements locally, for both convenience and exposure
management purposes. All industrial nations and most LDCs
have well-developed commercial banking systems, so firms
desiring local financing generally turn there first. The major
forms of bank financing include overdrafts, discounting, and
term loans. Nonbank sources of funds include commercial paper
and factoring (see Section 18.3, p. 650).
Bank Loans

Loans from commercial banks are the dominant form of short-
term interest-bearing financing used around the world. These
loans are described as selfliquidating because they are generally
used to finance temporary increases in accounts receivable and
inventory. These increases in working capital soon are
converted into cash, which is used to repay the loan.
Short-term bank credits are typically unsecured. The borrower
signs a note evidencing its obligation to repay the loan when it
is due, along with accrued interest. Most notes are payable in 90
days; the loans must, therefore, be repaid or renewed every 90
days. The need to periodically roll over bank loans gives a bank
substantial control over the use of its funds, reducing the need
to impose severe restrictions on the firm. To further ensure that
short-term credits are not being used for permanent financing, a
bank will usually insert a cleanup clause requiring the company
to be completely out of debt to the bank for a period of at least
30 days during the year.
Forms of Bank Credit.
Bank credit provides a highly flexible form of financing
because it is readily expandable and, therefore, serves as a
financial reserve. Whenever the firm needs extra short-term
funds that cannot be met by trade credit, it is likely to turn first
to bank credit. Unsecured bank loans may be extended under a
line of credit, under a revolving credit arrangement, or on a
transaction basis. Bank loans can be originated in either the
domestic or the Eurodollar market.
1.Term loans:Term loans are straight loans, often unsecured,
that are made for a fixed period of time, usually 90 days. They
are attractive because they give corporate treasurers complete
control over the timing of repayments. A term loan typically is
made for a specific purpose with specific conditions and is
repaid in a single lump sum. The loan provisions are contained
in the promissory note that is signed by the customer. This type
of loan is used most often by borrowers who have an infrequent
need for bank credit.
2.Line of credit: Arranging separate loans for frequent

borrowers is a relatively expensive means of doing business.
One way to reduce these transaction costs is to use a line of
credit. This informal agreement permits the company to borrow
up to a stated maximum amount from the bank. The firm can
draw down its line of credit when it requires funds and pay back
the loan balance when it has excess cash. Although the bank is
not legally obligated to honor the line-of-credit agreement, it
almost always does so unless it or the firm encounters financial
difficulties. A line of credit is usually good for one year, with
renewals renegotiated every year.
3.Overdrafts: In countries other than the United States, banks
tend to lend through overdrafts. An overdraft is simply a line of
credit against which drafts (checks) can be drawn (written) up
to a specified maximum amount. These overdraft lines often are
extended and expanded year after year, thus providing, in
effect, a form of mediumterm financing. The borrower pays
interest on the debit balance only.
4.Revolving credit agreement: A revolving credit agreement is
similar to a line of credit except that now the bank (or syndicate
of banks) is legally committed to extend credit up to the stated
maximum. The firm pays interest on its outstanding borrowings
plus a commitment fee, ranging between 0.125% and 0.5% per
annum, on the unused portion of the credit line. Revolving
credit agreements are usually renegotiated every two or three
years.
The danger that short-term credits are being used to fund long-
term requirements is particularly acute with a revolving credit
line that is continuously renewed. Inserting an out-of-debt
period under a cleanup clause validates the temporary need for
funds.
5.Discounting: The discounting of trade bills is the preferred
short-term financing technique in many European countries—
especially in France, Italy, Belgium, and, to a lesser extent,
Germany. It is also widespread in Latin America, particularly in
Argentina, Brazil, and Mexico. These bills often can be
rediscounted with the central bank.

Discounting usually results from the following set of
transactions: A manufacturer selling goods to a retailer on
credit draws a bill on the buyer, payable in, say, 30 days. The
buyer endorses (accepts) the bill or gets his bank to accept it, at
which point it becomes a banker's acceptance. The manufacturer
then takes the bill to his bank, and the bank accepts it for a fee
if the buyer's bank has not already accepted it. The bill is then
sold at a discount to the manufacturer's bank or to a money
market dealer. The rate of interest varies with the term of the
bill and the general level of local money market interest rates.
The popularity of discounting in European countries stems from
the fact that according to European commercial law, which is
based on the Code Napoleon, the claim of the bill holder is
independent of the claim represented by the underlying
transaction (e.g., the bill holder must be paid even if the buyer
objects to the quality of the merchandise). This right makes the
bill easily negotiable and enhances its liquidity (or tradability),
thereby lowering the cost of discounting relative to other forms
of credit.
Interest Rates on Bank Loans.
The interest rate on bank loans is based on personal negotiation
between the banker and the borrower. The loan rate charged to a
specific customer reflects that customer's creditworthiness,
previous relationship with the bank, maturity of the loan, and
other factors. Ultimately, bank interest rates are based on the
same factors as the interest rates on the financial securities
issued by a borrower: the risk-free return, which reflects the
time value of money, plus a risk premium based on the
borrower's credit risk. However, there are certain bank-loan
pricing conventions that you should be familiar with.
Interest on a loan can be paid at maturity or in advance. Each
payment method gives a different effective interest rate, even if
the quoted rate is the same. The effective interest rate is defined
as follows:
Suppose you borrow $10,000 for one year at 11% interest. If the

interest is paid at maturity, you owe the lender $11,100 at the
end of the year. This payment method yields an effective
interest rate of 11%, the same as the stated interest rate:
If the loan is quoted on a discount basis, the bank deducts the
interest in advance. On the $10,000 loan, you will receive only
$8,900 and must repay $10,000 in one year. The effective rate
of interest exceeds 11% because you are paying interest on
$10,000 but have the use of only $8,900:
An extreme illustration of the difference in the effective interest
rate between paying interest at maturity and paying interest in
advance is provided by the Mexican banking system. In 1985,
the nominal interest rate on a peso bank loan was 70%, about 15
percentage points higher than the inflation rate. But high as it
was, the nominal figure did not tell the whole story. By
collecting interest in advance, Mexican banks boosted the
effective rate dramatically. Consider, for example, the cost of a
Ps 10,000 loan. By collecting interest of 70%, or Ps 7,000, in
advance, the bank actually loaned out only Ps 3,000 and
received Ps 10,000 at maturity. The effective interest rate on the
loan was 233%:
Many banks require borrowers to hold from 10% to 20% of their
outstanding loan balance on deposit in a non-interest-bearing
account. These compensating balance requirements raise the
effective cost of a bank credit because not all of the loan is
available to the firm:
Usable funds equal the net amount of the loan less the
compensating balance requirement.
Returning to the previous example, suppose you borrow $10,000
at 11% interest paid at maturity, and the compensating balance
requirement is 15%, or $1,500. Thus, the $10,000 loan provides
only $8,500 in usable funds for an effective interest rate of
12.9%:

If the interest is prepaid, the amount of usable funds declines by
a further $1,100—that is, to $7,400—and the effective interest
rate rises to 14.9%:
In both instances, the compensating balance requirement raises
the effective interest rate above the stated interest rate. This
higher rate is the case even if the bank pays interest on the
compensating balance deposit because the loan rate invariably
exceeds the deposit rate.
Commercial Paper
One of the most favored alternatives for MNCs to borrowing
short term from a bank is to issue commercial paper. As defined
in Chapter 18, commercial paper (CP) is a short-term unsecured
promissory note that is generally sold by large corporations on a
discount basis to institutional investors and to other
corporations. Because commercial paper is unsecured and bears
only the name of the issuer, the market has generally been
dominated by the largest, most creditworthy companies.
Available maturities are fairly standard across the spectrum, but
average maturities—reflecting the terms that companies actually
use—vary from 20 to 25 days in the United States to more than
three months in the Netherlands. The minimum denomination of
paper also varies widely: In Australia, Canada, Sweden, and the
United States, firms can issue CP in much smaller amounts than
in other markets. In most countries, the instrument is issued at a
discount, with the full face value of the note redeemed upon
maturity. In other markets, however, interest-bearing
instruments are also offered.
By going directly to the market rather than relying on a
financial intermediary such as a bank, large, well-known
corporations can save substantial interest costs, often on the
order of 1% or more. In addition, because commercial paper is
sold directly to large institutions, U.S. CP is exempt from SEC
registration requirements. This exemption reduces the time and
expense of readying an issue of commercial paper for sale.

Three major noninterest costs are associated with using
commercial paper as a source of short-term funds: (1) backup
lines of credit, (2) fees to commercial banks, and (3) rating
service fees. In most cases, issuers back their paper 100% with
lines of credit from commercial banks. Because its average
maturity is very short, commercial paper poses the risk that an
issuer might not be able to pay off or roll over maturing paper.
Consequently, issuers use backup lines as insurance against
periods of financial stress or tight money, when lenders ration
money directly rather than raise interest rates. For example, the
market for Texaco paper, which provided the bulk of its
shortterm financing, disappeared after an $11.1 billion judgment
against the company. Texaco replaced these funds by drawing
on its bank lines of credit.
Historically, backup lines were paid for through compensating
balances, typically about 10% of the unused portion of the
credit line plus 20% of the amount of credit actually used. As an
alternative to compensating balances, issuers sometimes pay
straight fees ranging from 0.375% to 0.75% of the line of credit;
this explicit pricing procedure is now more commonly used.
Another cost associated with issuing commercial paper is fees
paid to the large commercial and investment banks that act as
issuing and paying agents for the paper issuers and handle all
the associated paperwork. Finally, rating services charge fees
ranging from $5,000 to $25,000 per year for ratings, depending
on the rating service. Credit ratings are not legally required by
any nation, but they are often essential for placing paper.
In Chapter 13, we saw that alternatives to commercial paper
issued in the local market are Euronotes and Euro-commercial
paper (Euro-CP). The Euronotes are typically underwritten,
whereas Euro-CP is not.
Calculating the Dollar Costs of Alternative Financing Options
This section presents explicit formulas to compute the effective
dollar costs of a local currency loan and a dollar loan.9 These
cost formulas can be used to calculate the least expensive
financing source for each future exchange rate. A computer can

easily perform this analysis—called break-even analysis—and
determine the range of future exchange rates within which each
particular financing option is the least expensive.
With this break-even analysis, the treasurer can readily see the
amount of currency appreciation or depreciation necessary to
make one type of borrowing less expensive than another. The
treasurer will then compare the firm's actual forecast of
currency change, determined objectively or subjectively, with
this benchmark.
To illustrate break-even analysis and show how to develop cost
formulas, suppose that DuPont's Mexican affiliate requires
funds to finance its working capital needs for one year. It can
borrow pesos at 45% or dollars at 11%. To determine an
appropriate borrowing strategy, this section develops explicit
cost expressions for each of these loans using the numbers just
given. Expressions are then generalized to obtain analytical cost
formulas that are usable under a variety of circumstances.
Case 1: No Taxes
Absent taxes and forward contracts, costing these loans is
relatively straightforward.
1.Local currency loan: We saw in Chapter 14 (Section 14.4, p.
526) that, in general, the dollar cost of borrowing local currency
(LC) at an interest rate of rL and a currency change of c is the
sum of the dollar interest cost plus the percentage change in the
exchange rate:
Employing Equation 19.1, we compute an expected dollar cost
of borrowing pesos for DuPont's Mexican affiliate of 0.45 × (1
+ c) + c, or 0.45 + 1.45c. For example, if the peso is expected to
fall by 20% (c =—0.20), then the effective dollar interest rate
on the peso loan will be 16% (0.45 − 1.45 × − 0.20).
2.Dollar loan: The Mexican affiliate can borrow dollars at 11%.
In general, the cost of a dollar (HC) loan to the affiliate is the
interest rate on the dollar (HC) loan rH.
Analysis.
The peso loan costs 0.45(1 + c) + c, and the dollar loan costs

11%. To find the break-even rate of currency depreciation at
which the dollar cost of peso borrowing is just equal to the cost
of dollar financing, equate the two costs—0.45(1 + c) + c =
0.11—and solve for c:
In other words, the Mexican peso must devalue by 23.45%
before it is less expensive to borrow pesos at 45% than dollars
at 11%. Ignoring the factor of exchange risk, the borrowing
decision rule is as follows:
If c <−23.45%, borrow pesos.
If c >−23.45%, borrow dollars.
In the general case, the break-even rate of currency change is
found by equating the dollar costs of dollar and local currency
financing—that is, rH = rL(1 + c) + c—and solving for c:
If the international Fisher effect holds, then we saw in Chapter
4 (Equation 4.15, p. 166) that c*, the break-even amount of
currency change, also equals the expected LC devaluation
(revaluation); that is, the expected peso devaluation should
equal 23.45% unless there is reason to believe that some form
of market imperfection is not permitting interest rates to adjust
to reflect anticipated currency changes.
9 This section draws on material in Alan C. Shapiro,
“Evaluating Financing Costs for Multinational Subsidiaries,”
Journal of International Business Studies, Fall 1975, pp. 25–32.
10 This application is adapted from Lars H. Thunell, “The
American Express Formula,” Euromoney, March 1980, pp. 121–
127.
Case 2: Taxes
Taxes complicate the calculation of various loan costs. Suppose
the effective tax rate on the earnings of DuPont's Mexican
affiliate is 40%.
1.Local currency loan: Chapter 14 presented the after-tax dollar
cost of borrowing in the local currency for a foreign affiliate as
equaling the after-tax interest expense plus the change in the
exchange rate, or

where ta is the affiliate's marginal tax rate. Employing Equation
19.3, we can calculate the after-tax dollar cost of borrowing
pesos as equaling 0.45 × (1 + c)(1 − 0.40) + c, or 0.27 + 1.27c.
2.Dollar loan: The after-tax cost of a dollar loan equals the
Mexican affiliate's after-tax interest expense, 0.11(1 − 0.40),
minus the dollar value to the Mexican affiliate of the tax write-
off on the increased number of pesos necessary to repay the
dollar principal following a peso devaluation, 0.4c.
In general, the total cost of the dollar loan is the after-tax
interest expense less the tax write-off associated with the dollar
principal repayment, or
Substituting the relevant parameters to Equation 19.4 yields an
after-tax cost of borrowing dollars equal to 0.11 × (1 − 0.40) +
0.4c, or 0.066 + 0.4c.
Analysis.
As in case 1, we set the cost of dollar financing, 0.066 + 0.4c,
equal to the cost of local currency financing, 0.27(1 + c) + c, in
order to find the break-even rate of peso depreciation necessary
to leave the firm indifferent between borrowing in dollars or
pesos.
The break-even value of c occurs when 0.066 + 0.4c = 0.27(1 +
c) + c, or
c* = −0.2345
Thus, the peso must devalue by 23.45% before it is cheaper to
borrow pesos at 45% than dollars at 11%. This is the same
break-even exchange rate as in the before-tax case. Although
taxes affect the after-tax costs of the dollar and LC loans, they
do not affect the relative desirability of the two loans. That is,
if one loan has a lower cost before tax, it will also be less costly
on an after-tax basis.
In general, the break-even rate of currency appreciation or
depreciation can be found by equating the dollar costs of local
currency and dollar financing and solving for c:

or
The tax rates cancel out and we are left with the same break-
even value for c as in the before-tax case (see Equation 19.2).
APPLICATION American Express Develops an
International Cash Management System
In early 1980, American Express (Amex) completed an eight-
month study of the cash cycles of its travel, credit card, and
traveler's check businesses operating in seven European
countries.10 On the basis of that project, Amex developed an
international cash management system that was expected to
yield cash gains—increased investments or reduced
borrowing—of about $35 million in Europe alone. About half of
these savings were projected to come from accelerated
collection of receipts and better control of disbursements. The
other half of projected gains represented improved bank-balance
control, reduced bank charges, improved value-dating, and
better control of foreign exchange.
The components of the system are collection and disbursement
methods, bank-account architecture, balance targeting, and
foreign exchange management. The worldwide system is
controlled on a regional basis, with some direction from the
corporate treasurer's office in New York. A regional treasurer's
office in Brighton, England, controls cash, financing, and
foreign exchange transactions for Europe, the Middle East, and
Africa.
The most advantageous collection and disbursement method for
every operating division in each country was found by
analyzing the timing of mail and clearing floats. This analysis
involved
• Establishing which payment methods were used by
customers in each country because checks are not necessarily
the primary method of payment in Europe
• Measuring the mail time between certain sending and
receiving points
• Identifying clearing systems and practices, which vary

considerably among countries
• Analyzing for each method of payment the value-dating
practice, the times for processing check deposits, and the bank
charges per item
Using these data, Amex changed some of its collection and
disbursement methods. For example, it installed interception
points in Europe to minimize the collection float.
Next, Amex centralized the management of all its bank accounts
in Europe on a regional basis. Allowing each subsidiary to set
up its own independent bank account has the merit of
simplicity, but it leads to a costly proliferation of different
pools of funds. Amex restructured its bank accounts,
eliminating some and ensuring that funds could move freely
among the remaining accounts. By pooling its surplus funds,
Amex can invest them for longer periods and also cut down on
the chance that one subsidiary will be borrowing funds while
another has surplus funds. Conversely, by combining the
borrowing needs of various operations, Amex can use term
financing and dispense with more expensive overdrafts.
Reducing the number of accounts made cash management less
complicated and also reduced banking charges.
The particular form of bank-account architecture used by Amex
is a modular account structure that links separate accounts in
each country with a master account. Management, on a daily
basis, has to focus only on the one account through which all
the country accounts have access to borrowing and investment
facilities.
Balance targeting is used to control bank-account balances. The
target is an average balance set for each account that reflects
compensating balances, goodwill funds kept to foster the
banking relationship, and the accuracy of cash forecasting.
Aside from the target balance, the minimum information needed
each morning to manage an account by balance targeting is the
available opening balance and expected debits and credits.
Foreign exchange management in Amex's international cash
management system focuses on its transaction exposure. This

exposure, which is due to the multicurrency denomination of
traveler's checks and credit card charges, fluctuates on a daily
basis.
Procedures to control these exposures and to coordinate foreign
exchange transactions center on how Amex finances its working
capital from country to country, as well as the manner in which
interaffiliate debts are settled. For example, if increased
spending by cardholders creates the need for more working
capital, Amex must decide whether to raise funds in local
currency or in dollars. As a general rule, day-to-day cash is
obtained at the local level through overdrafts or overnight
funds.
To settle indebtedness among divisions, Amex uses
interaffiliate settlements. For example, if a Swiss cardholder
uses her card in Germany, the Swiss credit card office pays the
German office, which in turn pays the German restaurant or
hotel in euros. Amex uses netting, coordinated by the regional
treasurer's office in Brighton, to reduce settlement charges. For
example, suppose that a German cardholder used his card in
Switzerland at the same time the Swiss cardholder charged with
her card in Germany. Instead of two transactions, one foreign
exchange transaction settles the differences between the two
offices.
This chapter examined the diverse elements involved in
international cash, accounts receivable, and inventory
management, as well as the short-term financing of foreign
affiliates. With regard to cash management, we saw that
although the objectives are the same for the MNC as for the
domestic firm—to accelerate the collection of funds and
optimize their use—the key ingredients to successful
management differ. The wider investment options available to
the multinational firm were discussed, as were the concepts of
multilateral netting, cash pooling, and multinational cash
mobilization. As multinational firms develop more efficient and
comprehensive information-gathering systems, the international

cash management options available to them will increase.
Accompanying these options will be even more sophisticated
management techniques than currently exist.
Similarly, we saw that inventory and receivable management in
the MNC involve the familiar cost-minimizing strategy of
investing in these assets up to the point at which the marginal
cost of extending another dollar of credit or purchasing one
more unit of inventory is just equal to the additional expected
benefits to be derived. These benefits accrue in the form of
maintaining or increasing the value of other current assets—
such as cash and marketable securities—increasing sales
revenue, or reducing inventory stock-out costs.
We also have seen that most of the inventory and receivables
management problems that arise internationally have close
parallels in the purely domestic firm. Currency changes have
effects that are similar to those of inflation, and supply
disruptions are not unique to international business. The
differences that do exist are more in degree than in kind.
The major reason why inflation, currency changes, and supply
disruptions generally cause more concern in the multinational
than in the domestic firm is that multinationals often are
restricted in their ability to deal with these problems because of
financial market constraints or import controls. When financial
markets are free to reflect anticipated economic events, there is
no need to hedge against the loss of purchasing power by
inventorying physical assets; financial securities or forward
contracts are cheaper and more effective hedging media.
Similarly, there is less likelihood that government policies will
disrupt the flow of supplies among regions within a country
than among countries.
We also examined the various short-term financing alternatives
available to a firm, focusing on parent company loans, local
currency bank loans, and commercial paper. We saw how
factors such as relative interest rates, anticipated currency
changes, the existence of forward contracts, and economic
exposure combine to affect a firm's short-term borrowing

choices. Various objectives that a firm might use to arrive at its
borrowing strategy were evaluated. It was concluded that if
forward contracts exist, the only valid objective is to minimize
covered interest costs. In the absence of forward contracts,
firms can either attempt to minimize expected costs or establish
some trade-off between reducing expected costs and reducing
the degree of cash-flow exposure. The latter goal involves
offsetting operating cash inflows in a currency with financing
cash outflows in that same currency.
This chapter also developed formulas to compute effective
dollar costs of loans denominated in dollars (home currency) or
local currency. These formulas were then used to calculate the
break-even rates of currency appreciation or depreciation that
would equalize the costs of borrowing in the local currency or
in the home currency.

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