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CHAPTER 1 INTRODUCTION Chapter 1 emphasizes the internationalization of business and economic activity that has occurred since the end of World War II. Although international business activities have existed for centuries, primarily in the form of exporting and importing, only in the postwar period have multinational firms become preeminent. The distinguishing characteristic of the MNC is its emphasis on global, rather than affiliate, performance. Specifically, MNCs ask, “Where in the world should we build our plants, sell our products, raise capital, and hire personnel?” Thus the true MNC is characterized more by attitude than the physical reality of an integrated, global system of marketing and production activities. It involves looking beyond the boundaries of the home country and treating the world as “our oyster.” After stimulating student interest with this vision of the MNC, I then introduce the financial decisions that MNCs must make. I begin by discussing the key concepts and lessons from domestic finance that apply directly to international corporate finance. The lessons include the empha¬sis on cash flow rather than accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to reward companies for activities (like corporate diversification) that investors could replicate for themselves at no greater cost. The key concepts, which I point out will arise time and again in the course, are arbitrage, market efficiency, and the separation of risk into systematic risk, which must be rewarded, and unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoretical framework of domestic corporate finance provides a useful frame of reference, and understanding it is essential before proceeding with the more complex aspects of international financial management. I devote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise, the astute student will see a conflict between the irrelevance of unsystematic risk and hedging activities. I then outline the key decision areas in international financial management: foreign exchange risk management, managing working capital and the internal financial system, financing foreign units, capital budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial executives must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as foreign exchange and political risks. SUGGESTED ANSWERS TO “THE DEBATE OVER OUTSOURCING” 1. What are the pros and cons of outsourcing? Answer: PROS: Outsourcing enables Americans to buy services less expensively abroad, increases U.S. productivity, and enables U.S. companies to cut their costs while improving quality, time to market, and capacity to innovate. It also allows the U.S. to use its comparative advantage in financial, managerial, and technical services by specializing in and exporting such services as higher-end computer programming, management consulting, engineering, banking, telecommunications, and legal work. CONS: As with any kind of trade, importing of services through outsourcing results in the loss of jobs for Americans previously employed in providing those services. Outsourcing may also cause U.S. companies that provide these services to go out of business. 2. How does outsourcing affect U.S. consumers? U.S. producers? Answer: As the answer to part a) points out, outsourcing allows companies to buy services less expensively abroad. Competitive pressures force companies to pass these savings along to consumers in the form of lower-priced goods and services. U.S. producers are able to boost productivity and cut costs while improving quality, time to market, and capacity to innovate. As such, American companies are better able to compete. This competition, however, forces companies to pass most of their savings from outsourcing through to their customers. 3. Longer term, what is the likely impact of outsourcing on American jobs? Answer: The longer-term effect of outsourcing on U.S. jobs should be insignificant. Trade has little, if anything, to do with the quantity of jobs in an economy but rather the nature and distribution of those jobs in various occupations. Outsourcing should lead to higher average productivity of those jobs that Americans work at and, hence, to higher wages and benefits. 4. Several states are contemplating legislation that would ban the outsourcing of government work to foreign firms. What would be the likely consequences of such legislation? Answer: Such legislation would result in less efficient and more expensive government. The end result would be higher taxes or, if taxpayers balk, fewer government services. SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS 1. Explain how globalization may affect even a small business in your local area. Answer: Globalization entails opening national borders to enable freer movement of goods and services. Due to the rapid decrease in communication and transportation costs over the last few decades, many firms find it cheaper to source products from foreign countries. Also, firms are now aware of international market opportunities and locate their plants and facilities abroad. As a result, the competition faced by any business is now more global rather than merely local. A small business in any local area now faces competition from both large MNCs and similarly situated businesses that take advantage of their international experience as well as internationally sourced products. 2. Opponents of globalization and outsourcing argue that locating manufacturing activities abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather than resulting in a net loss of jobs, employment has actually increased. Also, the average wages of workers have increased. How would your account for this discrepancy between what the critics say and what statistics reveal? Answer: Globalization is a two-way street. While some U.S. firms locate their plants overseas, several foreign companies have also invested in the U.S. economy and located their plants here. For example, major foreign automobile manufacturers such as Toyota and BMW have set up manufacturing plants in the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the U.S. economy has experienced unprecedented productivity growth due to the increase in trade from globalization. The net impact of this productivity growth as measured in output per hour has been such as to increase the inflation-adjusted worker compensation. Thus, while critics of globalization look at only one side of the picture and point to job losses due to outsourcing, they neglect to take into account the job creation due to foreign investment in the U.S. and the increase in trade due to globalization. Critics also ignore the fact the increased opportunities for trade due to globalization result in high-value-added services being performed in the U.S. and the increase in productivity of the U.S. worker. As a result, worker wages have also gone up. 3. Elaborate on the benefits of a proactive approach to globalization and global competition. Answer: Rather than react to globalization, firms benefit by facing globalization and global competition head on. Globalization and global competition unleash the forces of creative destruction, whereby new technologies and new methods of business force out poorly performing competitors. To take advantage of the full potential of globalization and to counter global competition, many firms adopt new technologies, improve production methods, explore new markets, and introduce new and better products. The results of such improvements are clear in terms of the lower prices and expanded choices for consumers. Thus, proactive firms stay ahead of their competition by taking advantage of the various benefits of globalization and the expanded trade opportunities. 4. What are the various reasons for the emergence of multinational firms? Answer: The primary reason for the emergence of MNCs is the international mobility of several factors of production. MNCs emerge to take advantage of globally available raw materials, markets, specialized skills, and knowledge. Also, firms may become multinational to keep domestic customers that have moved abroad or to exploit financial market imperfections. These are elaborated below. SEARCH FOR RAW MATERIALS: Some firms become MNCs to exploit the raw materials that can be found overseas, such as oil, coal, minerals, and other natural resources. MARKET SEEKING: Some firms become MNCs to exploit foreign markets for their products. Since the same product may be demanded in different countries, MNCs not only take advantage of the marketing opportunities, but also gain from the economies of scale obtained by selling large volumes across different foreign markets. COST MINIMIZATION: Companies also become MNCs to seek out lower-production-cost sites. Specific skills needed for production may be available at lower costs in some countries, and MNCs may locate plants specializing in specific aspects of production, such as assembly or fabrication, in those countries. KNOWLEDGE SEEKING: Some firms enter foreign markets to gain information and experience that are expected to prove useful elsewhere. Especially in industries characterized by rapid product innovation and technical breakthroughs, firms obtain technical product and process knowledge, which they leverage in other countries. KEEPING DOMESTIC CUSTOMERS: Suppliers of goods or services to MNCs often follow their customers abroad to guarantee them a continuing product flow. In the process, these firms also become MNCs. EXPLOITING FINANCIAL MARKET IMPERFECTIONS: Companies may find it advantageous to reduce taxes and circumvent currency controls when operating in multiple foreign markets. Doing so enables them to obtain greater project cash flows and lower costs of funds compared to a purely domestic firm. 5. Given the added political and economic risks that appear to exist overseas, are MNCs more or less risky than purely domestic firms in the same industry? Consider whether a firm that decides not to operate abroad is insulated from the effects of economic events that occur outside the home country. Answer: Individual foreign projects may face more political and economic risks than comparable domestic projects. Yet MNCs are likely to be less risky than purely domestic firms because much of the risk faced overseas is diversifiable. Moreover, by operating and producing overseas, the MNC has diversified its cost and revenue structure relative to what it would be if it were a purely domestic firm producing and selling in the home market. It is important to note that domestic firms are not insulated from economic changes abroad. For example, domestic firms face exchange risk because their competitive positions depend on the cost structures of both foreign and domestic competitors. Similarly, changes in the price of oil and other materials abroad immediately lead to changes in domestic prices. 6. How is the nature of IBM’s competitive advantages related to its becoming an MNC? Answer: IBM is selling more than black boxes; it is selling a stream of services associated with its computers. In effect, customers are buying the company. To provide customers with what they think they are buying, IBM must be there on the spot. This enables IBM to service customers’ machines as well as tailor software and systems to their specifications. 7. If capital markets were perfect, i.e., capital could move freely across national borders, would MNCs still exist? Why? Or, why not? Answer: Even if capital moved freely across national borders, MNCs would still exist, because MNCs bring a host of firm-specific knowledge and advantages along with capital to the countries in which they operate. Such advantages may include unique products, processes, technologies, patents, specific rights, or specific knowledge and skills. These advantages can be used profitably in foreign markets. Moreover, MNCs are better able to apply the knowledge and skills gained in their prior operations in other countries to each new country that they enter. Thus, from the point of view of a country attracting foreign capital, the capital that is brought in by an MNC brings with it firm-specific advantages that yield better returns than the capital that is simply borrowed from a foreign country. 8. What are the various ways in which domestic firms enter international markets? What are the benefits and risks of each strategy of foreign market entry? Answer: Three major ways in which domestic firms enter international markets are through exporting, licensing, and overseas production. When exporting, the domestic firm operates from its home country and merely sends its products overseas. In licensing, the domestic firm licenses its product, process, or technology to a foreign firm in return for royalties or other forms of payment. In overseas production, the domestic firm becomes an MNC by setting up a corporation overseas and engaging in manufacturing and/or marketing. The benefits and risks of each strategy are summarized below. Entry Benefits Risks Exporting • Minimal capital requirements and start-up costs • Risk is low • Profits are immediate • Learn about present and future supply and demand, competition, distribution channels, payment conventions, financial institutions, and financial techniques in host country • Relatively low risk compared to other entry strategies • Full sales potential of the product is not realized • Foreign importer is in greater control of marketing, and thus the image, of the firm’s branded products in the foreign country Licensing • Minimal investment requirements • Faster market-entry time • Fewer financial and legal risks • Cash flow is relatively low • May be problems in maintaining product quality standards • Foreign licensee may engage in unauthorized exports of the firm’s products, resulting in loss of future revenues for the licensing firm • Foreign licensee may become a strong competitor when license agreement ends Overseas Production • The firm can more easily stay abreast of market developments, adapt its products and production schedules to changing local tastes and conditions, fill orders faster, and provide more comprehensive after-sales service • Firm can exploit local skills, including R&D • Signals a greater commitment to the local market, which in turn increases sales and assurance of supply stability • Tremendous capital and top management commitment is required • Financial and operational risks are greater than those for other entry strategies • Companies face greater political risks, including the risk of expropriation of plants and facilities 9. Why do firms from each of the following categories become MNCs? Identify the competitive advantages that a firm in each category must have to be a successful MNC. a. Raw-materials seekers b. Market seekers c. Cost minimizers Answer: FDI is most likely to be economically viable where the possibility of opportunism on the part of unrelated parties or contractual difficulties make it especially costly to coordinate economic activities via arm’s length transactions in the marketplace. Firms go overseas to more fully utilize their skills and other tangible and intangible assets. RAW MATERIALS SEEKERS: The existence of low cost raw materials overseas is not a sufficient condition for firms to become MNCs; they could just import raw materials rather than set up operations abroad to extract them. Companies that become raw materials MNCs must a) Have intangible capabilities in the form of technical skills and face contractual difficulties in the form of an inability to price their know how or to write, monitor, and enforce use restrictions governing technology transfer arrangements; and b) Face problems of opportunism that make it very expensive to enter into long term purchase contracts to fully utilize their production or distribution capability. For example, an oil refining and distributing firm may find it too risky to invest in further refining capacity without controlling its own oil supply. An independent supplier may decide to break a contractual agreement and cut off the flow of oil to the refiner. MARKET SEEKERS: These firms usually have intangible capital in the form of organizational skills that are inseparable from the firm itself. A basic skill involves knowledge about how best to service a market, including new product development and adaptation, quality control, advertising, distribution, and after sales service. Since it would be difficult, if not impossible, 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. COST MINIMIZERS: These firms seek to reduce their costs by producing overseas. Yet the existence of lower cost production sites overseas is not sufficient to justify FDI. Since local firms have an inherent cost advantage over foreign investors, MNCs can succeed abroad only if the production or marketing edge they possess cannot be purchased or duplicated by local competitors. The successful MNC in this category will possess specialized design or marketing skills, a good distribution system, or own a strong brand name. Excess profits are earned on these intangible assets, not on the low foreign labor or materials costs. Overseas production just enables them to be cost competitive; it doesn't give them an edge since any competitor can replicate its production location. 10. What factors help determine whether a firm will export its output, license foreign companies to manufacture its products, or set up its own production or service facilities abroad? Identify the competitive advantages that lead companies to prefer one mode of international expansion over another. Answer: Here are some factors involved in deciding how to enter a market: i) PRODUCTION ECONOMIES OF SCALE: If these are important, then exporting might be appropriate. ii) TRADE BARRIERS: Companies that might otherwise export to a market may be forced by regulations to produce abroad, either in a wholly owned operation, a joint venture, or through a licensing arrangement with a local manufacturer. iii) TRANSPORTATION COSTS: These have the same effect as trade barriers. The more expensive it is to ship a product to a market, the more likely it is that local production will take place. iv) SIZE OF THE FOREIGN MARKET: The larger the local market, the more likely local production will take place, particularly if significant production economies of scale exist. Conversely, with smaller markets, exporting is more likely to take place. v) PRODUCTION COSTS: The real exchange rate, wage rates, and other cost factors will also play a part in determining whether exporting or local production takes place. vi) INTANGIBLE CAPITAL: If the MNC’s intangible capital is embodied in the form of products, exporting will generally be preferred. If intangible capital takes the form of specific product or process technologies that can be written down and transmitted objectively, foreign expansion will usually take the licensing route. If intangible capital takes the form of organizational skills that are inseparable from the firm itself, then the firm is likely to expand overseas via direct investment. vii) NECESSITY OF A FOREIGN MARKET PRESENCE: By investing in fixed assets abroad, companies can demonstrate to local customers their commitment to the market. This can enhance sales prospects. 11. Time Warner must decide whether to license foreign companies to produce its films and records or set up foreign sales affiliates to sell its products. What factors might determine whether it expands abroad via licensing or investing in its own sales force and distribution network? Answer: Some of the factors that Warner should consider in determining whether it expands abroad via licensing or by investing in its own sales force and distribution network are as follows: a) SALES VOLUME: It needs a certain minimum volume of business to justify its own sales force. b) POTENTIAL PROBLEMS OF OPPORTUNISM: How easy is it to monitor and control independent producers and sellers of its films and records? The easier it is to monitor and control them, the less value there is in having its own sales and distribution capability. c) CONFLICTS OF INTEREST: How motivated will independents be in pushing Time Warner’s products versus those of other companies? d) COLLATERAL BENEFITS TO WARNER: To the extent Time Warner gets other benefits from distributing its films (e.g., the sale of toys) that aren’t captured by independents, they will have less incentive to push Time Warner’s products than Time Warner will have. The more collateral benefits, the more important it is for Time Warner to control its own sales. e) THE IMPORTANCE OF MARKET INFORMATION: If products must be tailored to the foreign markets, Time Warner should probably develop its own sales force. Time Warner will find it difficult to gather the necessary market intelligence from independent distributors of its products. ADDITIONAL CHAPTER 1 QUESTIONS AND ANSWERS 1.a. What are the various categories of MNCs? Answer: Raw materials seekers, market seekers, and cost minimizers. 1.b. What is the motivation for international expansion of firms within each category? Answer: Raw materials seekers go abroad to exploit the raw materials that can be found there and can’t be found domestically. Market seekers go overseas to produce and sell in foreign markets. Cost minimizers invest in lower cost production sites overseas to remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than the home country and provides opportunities to gain additional supplies, sell more products, or find lower-cost sources of production. 2.a. How does foreign competition limit the prices domestic companies can charge and the wages and benefits workers can demand? Answer: As domestic producers raise their prices, customers begin substituting less-expensive goods and services supplied by foreign producers. The likelihood of losing sales limits the prices domestic firms can charge. Foreign competition also limits the wages and benefits workers can demand. If workers demand more money, firms have two choices: acquiesce to these demands or fight them. Absent foreign competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will face the same higher costs, they can cover these higher costs by all simultaneously raising their prices without fear of being undercut or of being placed at a competitive disadvantage relative to their peers. Foreign competition changes the picture because foreign firms’ costs will be unaffected by higher domestic wages and benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the market and take market share away. In this case, higher domestic costs will put domestic firms at a disadvantage vis-à-vis their foreign competitors. Recognizing this, domestic firms facing foreign competition are more likely to fight worker demands for higher wages and benefits. 2.b. What political solutions can help companies and unions avoid the limitations imposed by foreign competition? Answer: The classic political solution is protectionism. By limiting foreign competition either through tariffs or quotas, companies and workers limit the ability of foreign goods to restrain domestic price increases. The government can also subsidize domestic firms competing against foreign firms, allowing domestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes. 2.c. Who pays for these political solutions? Explain. Answer: Consumers pay for protectionism in the form of higher prices for their goods and services, fewer choices, and lower quality. Taxpayers pay for subsidies in the form of higher taxes or fewer of the other services provided by government. 3.a. What factors appear to underlie the Asian currency crisis? Answer: Asian countries had run up huge debts, mostly in dollars, and were depending on the stability of their currencies to repay these loans. Worse, Asian banks, urged on by the often-corrupt political leadership, were making loans to money-losing ventures controlled by political cronies. The result was financially troubled economies that could not generate the income necessary to repay their dollar loans. 3.b. What lessons can we learn from the Asian currency crisis? Answer: Financial crises can be avoided or mitigated if financial markets are open and transparent, thereby leading to investment decisions based on sound economic principles rather than cronyism or political considerations. Countries can stimulate healthier economies by avoiding policies that suppress enterprise, reward cronies, and squander resources on economically dubious, grandiose projects. 4.a. What is an efficient market? Answer: An efficient market is one in which new information is readily incorporated in the prices of traded securities. In an efficient market, one cannot expect to prosper by finding overvalued or undervalued assets. In addition, all funds require the same risk adjusted returns. Absent tax considerations or government intervention, therefore, market efficiency suggests that no financing bargains are available. 4.b. What is the role of a financial executive in an efficient market? Answer: In an efficient market, attempts to increase a firm’s value by purely financial measures or accounting manipulations are unlikely to succeed unless capital market imperfections or asymmetries in tax regulations exist. The net result has been to focus attention on those areas and circumstances in which financial decisions and financial managers can have a measurable impact. Key areas are capital budgeting, working capital management, and tax management. Circumstances to be aware of include capital market imperfections, caused primarily by government regulations, and asymmetries in the tax treatment of different types and sources of revenues and costs. As such, the role of the financial manager is to search for and take advantage of capital market imperfections and tax asymmetries to increase after-tax profits and lower the cost of capital. The value of good financial management is enhanced in the international arena because of the greater likelihood of market imperfections and multiple tax rates. In addition, the greater complexity of international operations is likely to increase the payoffs from a knowledgeable and sophisticated approach to internationalizing the traditional areas of financial management. 5.a. What is the capital asset pricing model? Answer: The CAPM quantifies the relevant risk of an investment and establishes the trade off between risk and return; i.e., the price of risk. It posits a specific relationship between diversification, risk, and required asset returns. In effect, the CAPM says that the required return on an asset equals the risk free return plus a risk premium based on the asset’s systematic or non-diversifiable risk. The latter is based on market wide influences that affect all assets to some extent, such as unpredictable changes in the state of the economy or in some macroeconomic policy variable, such as the money supply or the government deficit. 5.b. What is the basic message of the CAPM? Answer: The CAPM’s basic message is that risk is priced in a portfolio context. From this it follows that only systematic risk is priced; unsystematic risk, which by definition can be diversified away, is not priced and hence doesn’t affect the required return on a project. 5.c. How might an MNC use the CAPM? Answer: The CAPM can be used to estimate the required return on foreign projects. It can also help a company raise the right questions about risk when considering the desirability of a foreign project, the most important being which elements of risk are diversifiable and which are not. 6. Why might total risk be relevant for a multinational corporation? Answer: Higher total risk is relevant for an MNC because it could have a negative impact on the firm’s expected cash flows The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees, and thereby affect their willingness to commit themselves to relationships with the firm. In summary, total risk is likely to adversely affect a firm’s value by leading to lower sales and higher costs. Consequently, any action taken by a firm that decreases its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows. 7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the government penalize U.S. firms that invest overseas rather than at home. According to Reich, this kind of investment hurts exports and destroys well-paying jobs. Comment on this argument. Answer: The assumption underlying Secretary Reich’s memo is inconsistent with the empirical evidence. According to this evidence, U.S. firms that invest abroad tend to expand their exports. The jump in exports stems from the fact that by investing abroad, companies are able to expand their presence in foreign markets as well as protect foreign markets that would otherwise be lost to competitors. This enables them to sell more product, most of which is made in the U.S. In addition, the foreign plants tend to use components and capital equipment that are mostly made in and exported from U.S. plants. Penalizing U.S. companies that invest abroad would most likely lead to the loss of foreign markets as well as the additional exports that such markets generate. Such penalties would also reduce the efficiency of the world economy. After all, there is usually a sound economic reason for MNCs to invest abroad. 8.a. Are MNCs riskier than purely domestic firms? Answer: Although MNCs are confronted with many added risks when venturing overseas, they can also take advantage of international diversification to reduce their overall riskiness. We will also see in Chapter 16 that foreign operations enable MNCs to retaliate against foreign competitive intrusions in the domestic market and to more closely track their foreign competitors, reducing the risk of being blindsided by new developments overseas. 8.b. What data would you need to address this question? Answer: You would need to take relatively comparable firms in the same industry, but with different percentages of earnings from abroad, and compare the variability of their earnings. 9. Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain. Answer: Yes. International diversification may actually enable firms to reduce their total risk. Much of the general market risk facing a company is related to the cyclical nature of the domestic economy of the home country. Operating in a number of nations whose economic cycles are not perfectly in phase may, therefore, reduce the overall variability of the firm’s earnings. Thus, although the riskiness of operating in any one country may exceed the risk of operating in the U.S. (or other home country), much of that risk is eliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears to decline as firms become more internationally oriented. 10. In what ways do financial markets grade government economic policies? Answer: Traders and their customers receive a continuing flow of news from around the world. The announcement of a new policy leads traders to buy or sell currency, stocks, or bonds based on their evaluation of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be hurt by the policy. The result is a continuing global referendum on a nation’s economic policies, even before they are implemented. Politicians who pursue economic policies they perceive to be beneficial to them (e.g., improving their re election odds), even if these policies harm the national economy, usually don't appreciate the grades they receive. But the market is clear eyed and hard-nosed and will respond negatively to unsound fiscal and monetary policies. Politicians will not admit that their own policies led to higher interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame greedy speculators rather than their policies for the market’s response. 11. In seeking to predict tomorrow’s exchange rate, are you better off knowing today’s exchange rate or the exchange rates for the past 100 days? Answer: In an efficient market, which the foreign exchange market certainly appears to be, the current price of an asset such as a currency fully reflects all available information, including the complete price history. Thus, knowing today’s price is as informative from a forecasting standpoint as knowing all past prices. Past prices add nothing to the current price in terms of forecasting ability. 12. Why might setting up production facilities abroad lead to expanded sales in the local market? Answer: By producing abroad, a company can more easily keep abreast of market developments, adapting its products and production schedules to changing local tastes and conditions, while simultaneously providing more comprehensive after sales service. Establishing local production facilities also demonstrates a greater commitment to the local market and an increased assurance of supply stability. This is particularly important for firms that produce intermediate goods for sale to other companies. 13.a. How might total risk affect a firm’s production costs and its ability to sell? Give some examples of firms in financial distress that saw their sales drop. Answer: Higher total risk can lead to lower sales and higher production costs. The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees and thereby affect their willingness to commit themselves to relationships with the firm. Examples include Chrysler and Texaco, which saw their sales fall and costs of doing business rise when they were in financial distress. 13.b. What is the relation between the effects of total risk on a firm's sales and costs and its desire to hedge foreign exchange risk? Answer: Since total risk is likely to adversely affect firm value, by lowering sales and raising costs, any action taken by a firm that decreases its total risk will improve its sales and cost outlook, thereby increasing its expected cash flows. These effects help justify the range of corporate hedging activities designed to reduce total risk that MNCs engage in. SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS 1. In a satirical petition on behalf of French candlemakers, French economist Frederic Bastiat called attention to cheap competition from afar: sunlight. A law requiring the shuttering of windows during the day, he suggested, would benefit not only candlemakers but “everything connected with lighting” and the country as a whole. He explained: “As long as you exclude, as you do, iron, corn, foreign fabrics, in proportion as their prices approximate to zero, what inconsistency it would be to admit the light of the sun, the price of which is already at zero during the entire day!” 1.a. Is there a logical flaw in Bastiat’s satirical argument? Answer: No. Bastiat is precisely right. The objective of trade is to gain access to goods and services at lower quality-adjusted prices. The ultimate consequence is to make more efficient use of the world’s resources and thereby increase worldwide production and consumption. Protectionism aims to prevent this end. If protectionism succeeds, world output and consumption are lower than they might otherwise be because resources are not being put to their highest-value use. In the example cited by Bastiat, protectionism will lead to a squandering of resources by replicating what the sun can do less expensively. 1.b. Do Japanese automakers prefer a tariff or a quota on their U.S. auto exports? Why? Is there likely to be consensus among the Japanese carmakers on this point? Might there be any Japanese automakers that are likely to prefer U.S. trade restrictions? Why? Who are they? Answer: It depends. Both tariffs and quotas will lead to higher prices to U.S. consumers of imported Japanese cars. With tariffs, however, most of this price increase will go to the U.S. government in the form of tariffs. Japanese companies (or their dealers), on the other hand, will collect most, if not all, of the higher prices associated with the scarcity of imported Japanese cars. Once the Japanese producers hit their quota limit, they have no incentive to compete with each other by cutting price because they cannot sell more cars than they already are. The net result is that the U.S. market will be extraordinarily profitable to Japanese automakers, which it was. Since quotas tend to be allocated based on current sales, automakers like Toyota and Nissan with large market shares would prefer quotas, whereas automakers like Honda and Mitsubishi with smaller market shares would prefer tariffs. The reason for the latter’s preference for tariffs is that efficient companies can eventually overcome the effects of tariffs by cutting costs and prices, whereas efficiency counts for nothing with quotas. Regardless of the type of trade barrier imposed, U.S. automakers will raise their prices in line with higher import prices. However, U.S. automakers are likely to prefer quotas because quotas enable them to disguise the reason for higher U.S. car prices. Consumers would be much quicker to figure out the cause-effect relationship between higher tariffs and higher prices on U.S. and Japanese cars. 1.c. What characteristics of the U.S. auto industry have helped it gain protection? Why does protectionism persist despite the obvious gains to society from free trade? Answer: The U.S. auto industry has received as much protection as it has for two key reasons. First, it is a large and powerful industry. Second, it is concentrated in several politically important states, such as Michigan and Illinois. 2. Review the arguments both pro and con on NAFTA. What is the empirical evidence so far? Answer: NAFTA has helped increase international trade between the U.S., Mexico, and Canada. The results thus far indicate that NAFTA has created some jobs in both countries and cost some jobs. Indeed, the purpose of free trade is not to create jobs but to increase the purchasing power and choice of consumers. With respect to jobs, the effect of free trade is to create higher-paying jobs that replace lower-paying jobs. The number of jobs in an economy is independent of the presence or absence of trade. It has everything to do with the incentives that people have to work, their productivity, and the costs to employers of hiring workers. What trade does is permit workers to hold jobs in those areas of the economy in which the nation has a comparative advantage. At the same time, trade destroys jobs in those goods and services in which the nation is at a comparative disadvantage. 3. Given the resources available to them, countries A and B can produce the following combinations of steel and corn. Country A Country B Steel (tons) Corn (bushels) Steel (tons) Corn (bushels) 36 0 54 0 30 3 45 9 24 6 36 18 18 9 27 27 15 12 18 36 6 15 9 45 0 18 0 54 3.a. Do you expect trade to take place between countries A and B? Why? Answer: Yes. Given the data presented, if country A has 6 units of resources and it devotes X of these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X) bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production functions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel in country B. These relative prices indicate that country A has a comparative advantage in the production of steel, whereas B has a comparative advantage in the production of corn. 3.b. Which country will export steel? Which will export corn? Explain. Answer: Given these comparative advantages, A will export steel and B will export corn. The price of corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of corn. Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954
