Problem Set 3 International Finance

Answer. The company that gets to market first often goes on to dominate it. Those companies that don't invest early may quickly be out of the business altogether. They may also lose out on other opportunities that were not foreseen at the time of the investment decision, but that developed later. For example, a company that forgoes investment in a novel technology passes up the chance to explore its technical possibilities, market opportunities, development costs, and competitors' strategies. In other words, initial expenditures on product and process technologies and market position should be viewed as investments in information and in the creation of options to utilize that information in ways that may not have been envisioned originally. For example, Merck, the pharmaceutical firm, decided to invest in an automated packaging and distribution plan, even though the labor savings didn't justify the investment, in order to explore the potential benefits of plant automation. Results from the pilot project have clarified these benefits to the point that Merck is now expanding automation to its diverse manufacturing operations. Thus, firms that forgo investments in are passing up the chance to create and act on options. And the fact that a company passes up the chance to invest in options does not mean that its competitors will. For example, an auto maker may give up on ceramic engines, because technically they seem infeasible. But a rival who makes prosaic ceramic parts with the aim of one day using the knowledge to build a ceramic engine--as the Japanese are doing--can quickly change the competitive balance. Similarly, although liquid crystal displays (LCDs) are a U.S. invention (they were developed by RCA, which abandoned them as uneconomic), Japanese companies used them to make watches and small TVs; now they lead in LCD flat-panel computer screens. The ability to make these displays are a major reason Toshiba and other Japanese firms have won a large share of the laptop computer market. Moreover, the advanced display screens used in laptops not only are important as computer screens but also promise to open up huge markets in all types of display technology from cockpit, medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV.

B. MNC Capital Budgeting and Taxation

Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California, manufacturer of disk drive controllers, is trying to decide whether to switch to offshore production. Given Xebec's well  developed engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking full advantage of both low wage labor and a grab bag of tax holidays, low interest loans, and other government largess. Most of his competitors seemed to be doing it. the faster he followed suit, the better off Xebec would be according to the conventional discounted cash flow analysis, which shows that switching production offshore is clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of certain intangible strategic benefits associated with domestic production.

a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its customers are all U.S. firms and that manufacturing technology  particularly automation skills  is key to survival in this business.
Answer. Short run benefits include better quality control, better communication with customers, and the ability to adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a laboratory in which to apply the latest thinking about automated production. By working with the production process on a daily basis, Xebec would have a better sense of the technology's wider potential, of possible applications that it would otherwise not think about. For example, running a highly automated manufacturing operation next door to the engineering group would enable Xebec to provide production related input in the early stages of product design  something that offshore production managers can rarely do. And with successfully automated production, Xebec's new disk drives could be offered with a price and quality level to match those of potential competitors from Japan or anywhere else. By contrast, contracting to have its products built for it by a potential competitor in a country like Taiwan or Japan might cost Xebec both market share and its technological edge.
The video recorder is a classic example of how production know how can yield important technical advances. Sony, along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professional use product from the United States that cost $20,000 or more and turned it into a $1,500 home product with a relatively small market. Japanese designers then worked closely with Japanese factories to make every component smaller and less expensive. Cooperation between Matsushita's design teams and employees on the shop floor eliminated more than three quarters of the product's cost while dramatically improving its quality. In the process, the company turned a niche product into the mass market success story of the 1980s.
b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing (which are intangible costs of offshore production) into the factory location decision?
Answer. The intangible strategic benefits of domestic manufacturing can be factored into the factory location decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and benefit from expanding into new products or markets or new process technologies. Whether Xebec will exercise these growth options depends on what happens in the future, which is unknowable today.
The value of these growth options depends on several factors:

1. The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before responding to changes in the marketplace (since automation enables it to respond so quickly once it decides to). The investment in automation also provides Xebec with a set of long lasting skills.
2. The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in automation is likely to be especially valuable since it so risky.
3. The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options.
4. The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared with others. Learning about the automation process is clearly a proprietary skill and so more valuable than investing in a new piece of equipment that everyone has access to.
Valuing an investment in automation which embodies discretionary follow up projects requires an expanded net present value rule that considers the attendant options. More specifically, the value of an option to undertake a follow up project equals the expected NPV from investing in the project using the conventional discounted cash flow analysis plus the value of the discretion associated with undertaking the project.
c. How would the possibility of radical shifts in manufacturing technology affect the production location decision?
Answer. The possibility of radical shifts in manufacturing technology would increase the benefits from investing in factory automation in the U.S. The phrase "radical shifts" implies that the project is high risk, which increases the option component of value.
For example, companies that in the mid 1970s made the transition from electro mechanical manually operated machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities  much higher performance at much lower cost  of the microprocessors and microcontrollers that became available in the early 1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when they became available. Companies that had deferred investment in the emerging electronic technology were not able to participate in the great technological advances in microelectronics; they had not acquired an option in this new process technology.
d. Xebec is considering producing more sophisticated drives that require substantial customization. How does this possibility affect its production decision?
Answer. The more customization is required, the more important it is to work closely with the customer. To meet the exacting needs of customers, there must be close personal contract between Xebec's engineering and production staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of the marketing, engineering, design, and manufacturing people when they are spread around the globe. The need for coordination increases the value of domestic production facilities.
e. Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to Xebec to build a factory there. The loan would be paid off in equal annual installments over a five year period. If the market interest rate for such an investment is 14%, what is the before tax value of the interest subsidy?
Answer. Borrowing at 5% when the market rate of interest is 14% saves Xebec 9% annually on the principal balance outstanding. This leads to annual before tax savings and their associated present values as follows: