international

BERTOS MANUFACTURING CORPORATION

Evaluating Markets to Invest Abroad

E. N. Roussakis and Anastasios Moysidis

Abstract: This case deals with the key considerations when planning an international

expansion through direct investment in foreign markets. These considerations must be addressed by a finance company seeking to establish foreign subsidiaries to support the

international sales of its parent firm, a U.S.-based multinational enterprise (MNE). The

company already operates three foreign subsidiaries--in Canada, Mexico (both NAFTA

members), and the United Kingdom--but wishes to increase this network further through

entry into additional markets. Ten candidate countries are being considered to determine

the five most suitable for entry. Hence the need for a rational decision of where to invest.

Keywords: Subsidiaries; multinational enterprise; transnational activities; foreign direct

investment; greenfield investment; leveraged institution; wholesale financing; captive

finance company; retail installment contract

1 Introduction

Victoria Pernarella is a recent university graduate in business administration and a new

hire in Bertos Financial Services, Inc., a major finance company in Nashville, Tennessee.

After a month long rotational training to gain insights into the company‟s scope of

activities, she was placed in the international department where she has been assigned to

work on a project. Bill Pappas, her manager, had asked her to analyze a select number of

foreign countries to determine the best prospects for the local establishment of subsidiary

finance companies. He went on to clarify that the mode of entry into the foreign markets--

acquisition of an existing company or a greenfield investment (from the ground up, that is,

from a green field)--was not a primary consideration at this stage. The candidate countries

were Argentina, Australia, Brazil, China, France, Netherlands, Russia, Switzerland,

Turkey, and Venezuela. With finance companies highly leveraged institutions, the firm

was prepared to provide the initial amount of equity capital needed for the establishment

of five such institutions. At this stage therefore, the study ought to limit its

recommendation to a corresponding number of foreign countries.

With this information at hand, Victoria started reflecting on the approach to use for

her analysis. Sensing the need to prove her capabilities by delivering a high quality study

for her first company assignment, she thought appropriate to first familiarize herself with

the pertinent literature on the international expansion of multinational enterprises (MNE)

in general and banks in particular, and then review background information on her

employer, and the scope of activities of its financial subsidiary. Hence the sequence of the

following sections which address the internationalization process (literature review on the

development of MNEs), the modes of bank entry into foreign markets, background of

parent company, financial subsidiary and scope of activities, and developing criteria for

country recommendation.

2 Internationalization Process--A Theoretical Perspective

Recent decades have witnessed the internationalization of operations of many companies

around the world, and especially U.S. corporations. Although the extent, form and pattern

of their transnational activities vary according to the characteristics of the firms, the

products they produce, and the markets in which they operate, they all reflect the

dynamics of a changing and increasingly competitive international environment. Of the

theories that have sought to explain the transnational activities of enterprises, the eclectic

paradigm (Dunning, 1988) enjoys a dominant position. This concept provides a broad

framework for the alternate channels of international economic involvement of enterprises

and focuses on the parameters that influence individual MNE foreign investment decisions

(Buckley and Casson, 1976; Dunning, 1977). Specifically, the eclectic paradigm identifies

three important determinants in the transnational activities of firms-- ownership, location

and internalization (OLI). The first condition of the OLI configuration states that a firm

must possess certain owner-specific competitive advantage in its home market that can be

transferred abroad if the firm‟s foreign direct investment (FDI) is to be successful. This

advantage must be firm-specific, not easily copied, transferable, and powerful enough to

compensate the firm for the potential disadvantages and risks of operating abroad. Certain

ownership-specific competitive advantages enjoyed in the home market, such as financial

strength and economies of scale, are not necessarily firm-specific because they can be also

attained by other firms. Similarly, certain types of technology do not ensure a firm-

specific advantage because they can be purchased, licensed or copied. Production and

marketing of differentiated products, too, can lose their competitive edge to modified

versions of such products promoted by lower pricing and aggressive marketing.

The second strand in the OLI model stands for location-specific advantages. That

is, the foreign market must possess certain characteristics that will allow the firm to

exploit its competitive advantages in that market. Choice of location may be a function of

market imperfections or of genuine comparative advantages of particular places. Other

important considerations that may influence the locational decision may include a low-

cost but productive labor force, unique sources of raw materials, formation of a custom

unions or regional trading bloc, defensive investments to counter a firm‟s competitors, or

centers of advanced technology.

The third component of the OLI paradigm is internalization and refers to the

importance for a firm to safeguard its competitive position by maintaining control of its

entire value chain in its industry. This can be accomplished through foreign direct

investment rather than licensing or outsourcing. Transferring proprietary information

across national boundaries within its own organization would enable a firm to maintain

control of its firm-specific competitive advantage. Establishment of wholly-owned

subsidiaries abroad reduces the financial agency costs that arise from asymmetric

information, lack of trust and the need to monitor foreign partners, vendors, and financial

intermediaries. Further, if the parent firm funds the operations of its foreign subsidiaries,

self-financing eliminates the need to observe specific debt provisions that would result

from local financing. If a multinational firm has access to lower global cost and greater

availability of capital why subject its operations to local financial norms or share these

important advantages with local joint venture partners, distributors, licensees, and banks

that would probably have a higher cost of capital.

Of the three premises of the paradigm described above, the second strand

(locational advantage) has been the subject of increased treatise. Although in theory

market imperfections and comparative advantage are key considerations in determinin g

the attractiveness of particular locations, in practice firms have been observed to follow a

search pattern influenced by behavioral factors. As rational decisions require availability

of information and facts, determining where to invest abroad for the first time is

significantly more challenging than where to reinvest abroad. The implication is that a

firm learns from its operations abroad and what it learns influences subsequent decisions.

This premise lies behind two related behavioral theories of foreign direct investment

decisions--the behavioral approach and international network theory. The former,

exemplified by the Swedish School of economists (Johansen and Wiedersheim-Paul,

1975; Johansen and Valhne, 1977), sought to explain both the initial and later FDI

decisions of a sample of Swedish MNEs based on these firms‟ scope of international

operations over time. The study identified that these firms favored initially countries in

“close psychic distance”; that is, they tended to invest first in countries that possessed a

similar cultural, legal, and institutional environment to that of Sweden‟s, e.g., in such

countries as Denmark, Finland, Norway, Germany and the United Kingdom. As the firms

gained knowledge and experience from their initial operations, they tended to accept

greater risks both in terms of the countries‟ psychic distance and the size of their

investments.

The development and growth of Swedish companies over time, contributed to a

transformation in the nature of the parent/foreign-subsidiary relationship. The

international network theory addresses this transformation by identifying such changes as

the evolution of control from centralized to decentralized, nominal authority of the parent

firm over the organizational network, foreign subsidiaries competing with each other and

with the parent for resource allocations, and political coalitions with competing internal

and external networks.

Some authors (Eiteman et al., 2010) view the internationalization of operations as

an outgrowth of sequential stages in the development of a firm. They refer to this

progression in the scope of business activity as the globalization process and identify three

distinct phases. In the domestic phase, a company sells its products to local customers, and

purchases its manufacturing and service inputs from local vendors. As the company

grows to become a visible and viable competitor at home, imperfections in foreign

national markets or comparative advantages of particular locations translate into market

opportunities and provide the impetus for an expansion strategy. Entry into one or more

foreign markets will make the company attain the international trade phase. At this stage

the company imports its inputs from foreign suppliers and exports its products and

services to foreign buyers. In this facet, the firm faces increased challenges of its financial

management, over and above the traditional requirements of the domestic-only phase.

Exports and imports expose the firm to foreign exchange risk as a result of currency

fluctuations in global markets. Moreover, they expose the firm to credit risk management;

assessing the credit quality of the foreign buyers and sellers is more formidable than in

domestic business. When the firm senses the need to set up foreign sales and service

affiliates, manufacture abroad or license foreign firms to produce and service its products,

it progresses to the third phase, the multinational phase. Many multinational enterprises

prefer to invest in wholly owned subsidiaries to maintain effective control of their

competitive advantage and any new information generated through research. Ownership

of assets and enterprises in foreign countries exposes the firm‟s FDI to political risk--

political events that can undermine the economic viability and performance of the firm in

those countries. Political risk can range from seizure of property (expropriation) and

ethnic strife to conflict with the objectives of the host government (governance risk) and

limitations on the ability to transfer funds out of the host country (blocked funds).

Figure 1 portrays the sequential stages in a firm‟s international expansion and

provides an overview of the globalization process and the FDI decision. For a firm with a

competitive advantage in its home market, a typical sequence in its international

expansion would be the reach to one or more foreign markets by first using export agents

and other intermediaries before engaging in direct dealings with foreign agents and

distributors. As the firm learns more about foreign market conditions, payment

conventions and financial institutions it feels more confident in establishing its own sales

subsidiary, service facilities and distribution system. These moves culminate in foreign

direct investments and control of assets abroad. Some of these assets may have been built

from the ground up, or acquired through purchase of an existing firm or facility. As the

level of physical presence in foreign markets increases so does the size of foreign direct

investment.

3 Modes of Bank Entry into Foreign Markets

Unlike industrial and manufacturing firms which have expanded internationally along the

patterns suggested above (eclectic paradigm and globalization process), financial

institutions have entered foreign markets primarily in response to the needs of their

business clients. Indeed, this has been the case for commercial banks, the oldest and most

dominant institution of the U.S. financial system. The growth of multinational

corporations and the accelerating pace of globalization in business activity increased the

demand for international financial services and induced the expansion of banks‟

international operations and presence abroad. Whether proactively (to enhance own

growth and profitability) or defensively (to deny a competitor the benefit of the client‟s

business), banks have sought to enter foreign markets early and quickly to gain from the

first-mover advantage. The rush of Western banks into Central and Eastern Europe in the

1990s exemplifies the drive to gain this first-mover advantage (Hughes and MacDonald,

2004).

In weighing entry into a foreign market a number of factors must be taken into

account, including the bank‟s resources (both financial and human), projected volume of

international business, knowledge of--and experience with--foreign markets, banking

structure and regulation in the countries targeted for entry, tax considerations, and

customer profile. A key variable in the decision process is the vehicle to be used in the

delivery of international services. Major banks around the world have used anyone or a

combination of vehicles to structure their international operations. The lowest possible

level of presence in a foreign market may be attained through a correspondent banking

relationship--using a native institution to provide the financial services needed in that

market. This approach may be duplicated in one or more countries abroad, as needed, for

the processing of international transactions. It entails no investment and hence no

exposure to the foreign market. Extension of services may be based on a reciprocal

deposit account between the banks or an individual fee per transaction. A representative

office enables a physical presence in a foreign market. However, it cannot provide

traditional banking services; it can only engage in such activities as serving as a liaison

and performing marketing function for the parent bank. As it does not constitute a legal

entity it has no legal or tax liability. An agency may perform more functions than a

representative office but cannot perform all banking functions (e.g., in the United States a

foreign bank agency may extend local loans but cannot accept local deposits). The

principal vehicle used by U.S. banks in the conduct of their activities internationally is the

branch office. This office is a legal and operational part of the parent bank, backed the full

resources of the parent in the performance of the banking functions permitted by the host

country. Although it requires a sizable investment it enables the provision of full banking

services which the prior vehicles do not. A branch office is subject to two sets of

regulation--those of the home country and those of the host country. A subsidiary is a

separate legal entity organized under the laws, and hence regulated by the authorities, of

the host country. It is the second most important vehicle used by commercial banks for the

conduct of banking business, and may be established as a new organization or through the

purchase of an existing institution. Whatever the approach used in its establishment, a

subsidiary offers two important advantages over a branch: it may provide for a wider

range of services, and it limits the liability of the parent bank to the amount of its equity

investment in that entity. The main disadvantage of a subsidiary is that it must be

separately capitalized from the parent bank, which may often entail a greater start up

investment than a branch (Rose and Hudgins, 2010).

U.S. finance companies interested to expand their activities internationally take

into account many of the same criteria used by banks. In structuring their international

operations U.S. finance companies favor the subsidiary organizational form because of the

advantages associated with this type of vehicle. Just as in U.S. financial markets, foreign

financial subsidiaries are heavy users of debt in financing their operations. Principal

sources of borrowed funds include bank credits and issues of debt (e.g., bonds) in capital

markets to finance their lending activities in their respective markets (Madura, 2011;

Gitman et al., 2010). Finance companies are extremely diversified in their credit granting

activities, offering a wide range of loans, leasing plans and long term credit to support

capital investment. One of the most important markets for finance companies has been

the extension of business-oriented financial services including working capital loans,

revolving credit and equipment lease financing.

4 Background of Parent Company

Bertos Manufacturing Corporation (BMC) is one of the largest companies of the country

in the manufacturing of construction and mining equipment, and engines. BMC draws its

origin in a California firm organized in 1890 to manufacture steam-powered tractors for

farming. The firm was nominally capitalized and aspired to make inroads in the local

market by having its tractors plow California fields. However, soon after the turn of the

century, an abandoned manufacturing plant by a failed tractor company in a major

manufacturing center in Illinois was instrumental in the relocation of operations in the

Midwest. The location of this center on the Mississippi River made it a prime

transportation hub offering important prospects for the young company. Indeed, the move

proved a turning point in the development of the company. Domestic sales grew so

significantly that by 1911 the factory employed a little over 600 individuals. A natural

consequence of the domestic momentum was the firm‟s entry into foreign markets

through tractor exports to Argentina, Mexico, and Canada.

World War II was a company milestone as it created a sharp increase in the

demand for tractors to built airfields and other military facilities in strategic sites of the

Pacific. However, it was during the post-war construction boom that the company grew at

a rapid pace. A series of mergers and acquisitions diversified operations into the current

scope of products and contributed to BMC‟s growth to an industrial company of national

and international dimension. A successful export-oriented strategy led to the establishment

of a manufacturing venture outside the United States in 1950, which marked the beginning

of BMC‟s development into a multinational corporation. The company operates in two primary lines of business: machinery and engines.

The machinery line of business designs manufactures and sells construction, mining, and

forestry machinery, including track and wheel tractors, hydraulic excavators, pipe layers,

log loaders, off highway trucks, and related parts. The engines business line designs,

manufactures and sells diesel and natural gas engines and gas turbines, which, in addition

to their use in the company's own machines and vehicles, provide power for boats, ships

and locomotives.

The recent financial crisis (2008) led to the restructuring of operations and

renewed management‟s commitment to fuel efficiency, quality, technology and safety of

the company‟s machinery and engine products. Overall, BMC manufactures some 400

products which are sold both at home and abroad through a network of dealers. The

company has a worldwide network of 220 dealers: 63 dealers in the United States and 157

in other countries. To accommodate domestic and international demand for its products

and components the company has built 109 plants in different part of the world. Of these,

51 plants are located in the United States and 58 in foreign countries, namely, Australia,

Belgium, Brazil, Canada, England, France, Germany, Hungary, India, Indonesia, Italy,

Japan, Mexico, the Netherlands, Northern Ireland, the People's Republic of China, Poland,

Russia, South Africa and Sweden. The company also licenses or subcontracts the

manufacture of BMC-branded clothing, hats, footwear, and other consumer products.

To support higher volumes, growth and new product introductions, BMC‟s

worldwide employment is a little over 100,000, split evenly between the United States and

the rest of the world. Consolidated revenue last year amounted to about $45 billion and

net profit (after taxes) $3.5 billion (Table 1). More than half of the total revenue was

generated outside the United States, while the North American market was the single

largest source. A breakdown of revenues by geographic region is provided in Table 2.

Although this performance represents the culmination of an effective international

strategy, BMC has been increasingly concerned about its future potential in the global

market place. Its board of directors has recognized that although opportunities for future

growth exist, international competition may undermine the maximization of consolidated

after-tax returns. To offset the effects of such a trend, the board, in its last meeting,

decided to explore new avenues for growth. A top prospect was the international

expansion of financial services to support the overseas dealer sales of BMC products.

5 Financial Subsidiary and Scope of Activities

Following the practice of other industry leaders (e.g., General Electric, Motorola, and

Ford Motor Company), BMC established a wholly-owned, and separately incorporated,

finance company to perform a dual function--to accommodate the credit needs of the

parent but most importantly to finance parent company sales (hence the reference to such

a firm as a captive finance company). Established in Nashville, Tennessee, Bertos

Financial Services, Inc. (BFSI) promotes the sale of the parent's products and services by

engaged in the extension of credit. Specifically, BFSI extends wholesale financing to, and

purchases retail installment contracts from, franchised dealers. Also, it offers various

forms of insurance to customers and dealers to support the purchase and lease of

equipment. Table 3 identifies the location of BFSI offices in the United States and the

geographical market covered by each office. The company‟s domestic network includes

10 regional offices and a wholly-owned subsidiary which engages solely in the financing

and leasing of construction and trucking industry equipment on a national scale. Table 3

also identifies BFSI‟s current presence abroad which is limited to three subsidiaries

located in the following countries--Canada and Mexico (both members of the North

American Free Trade Agreement), and the United Kingdom.

In its last meeting the BMC board felt that if the spectrum of credit activities

pursued at home could be duplicated abroad it would add important impetus i n the

company‟s international growth momentum. The board believes that establishment of

finance companies in an additional number of select foreign countries would be

instrumental in maximizing corporate investment returns. To this end it has requested an

in-house study to screen foreign prospects and expressed the interest to review

recommendations in its forthcoming meeting. It was under these circumstances that Bill

Papas assigned the task for this study to Victoria.

6 Developing Criteria for Country Recommendation

To screen the best five prospects among the ten candidate countries for the establishment

of subsidiary finance companies, Victoria thought appropriate to develop a set of criteria

on which to base her recommendation. Although she could readily identify several key

criteria, she felt she should give also due consideration to the rules and regulations

governing bank operations in the candidate countries. Granted that the objective was not

to set up commercial banks but finance companies; however, the banking regulatory

framework provided an indication of the kind of credit and financial environment

prevailing in these countries.

Although the focus of her study was the best five foreign prospects, she felt

important to defend her recommendation by also addressing the weaknesses of the

excluded countries. She realized that this classification was only pertinent under present

circumstances and that some of the excluded countries could realize latent opportunities to

qualify for entry at a later time.

7 Assignment

1. Identify the key criteria and considerations that need to be taken into account in

evaluating BFSI entry in the proposed foreign markets.

2. Of the countries under consideration, which five would be most suitable for the

immediate establishment of a BFSI subsidiary? Highlight the key issues for each of the

selected countries and discuss the reasoning behind your recommendation.

3. Which countries would be unsuitable for a BFSI subsidiary at this time, and what are

the basic shortcomings in each case?

Figure 1 The FDI sequence: foreign presence and foreign direct investment

Source: Eiteman et al (2010), Figure 16.8 © 2010 Pearson Education, Inc.

Reproduced by permission of Pearson Education, Inc.

Table 1 Financial highlights of BMC

_____________________________________

Items Billions of dollars

Total revenues $44.9

Profit after taxes 3.5

Assets 56.1

Stockholders‟ equity 8.9

_____________________________________

Source: Authors‟ analysis

Table 2 Breakdown of revenues by geographic region

__________________________________________________

Region Billions of dollars Percent

North America $19.7 43.88

EAME* 14.3 31.85

Latin America 4.5 10.02

Asia Pacific 6.4 14.25

Total $ 44.9 100.00

___________________________________________________

*Europe, Africa, and the Middle East.

Source: Authors‟ analysis

Table 3 Bertos Financial Services, Inc.: Operations in the United States and abroad

________________________________________________________________________

Domestic Offices and Market Area Covered

Charlotte, North Carolina: Charlotte Area

Tempe, Arizona: Denver Area

Weatogue, Connecticut: Hartford Area

Houston, Texas: Houston Area

Jacksonville, Florida: Jacksonville Area

Rancho Santa Margarita, California: Los Angeles Area

Lenexa, Kansas: Minneapolis Area

Brentwood, Tennessee: Nashville/Indianapolis Area

Peoria, Illinois: Peoria Area

Bellevue, Washington: Seattle Area

Atlanta, Georgia: U.S. Equipment Financing Inc.

Subsidiary Companies Abroad

Canada

Bertos Financial Services, Inc.

Toronto, Ontario

Mexico

Grupo Financiero Bertos Mexico, S.A. de C.V.

Monterrey, Nuevo León

United Kingdom

Bertos Financial Services Limited

Birmingham, West Midlands

_______________________________________________________________________

References

Buckley, P. and Casson, M. (1976) „The Future of Multinational Enterprise’, McMillan.

Dunning, J.H. (1977) „Trade location of economic activity and the MNE: a search for

an Eclectic approach‟, in The International Allocation of Economic Activity, Bertil

Ohlin, Per-Ove Hesselborn, and Per Magnus Wijkman, eds., Holmes and Meier,

pp. 395-418.

Dunning, J.H. (1988) „The eclectic paradigm of international production: a restatement

and some possible extensions‟, Journal of International Business Studies, Vol.19,

No. 1, pp. 1-31.

Eiteman, D., Stonehill, A. and Moffett, M. (2010) „Multinational Business Finance’,

Twelfth Edition, Prentice Hall.

Gitman, L., Joehnk, M. and Billingsley, R. (2011) Personal Financial Planning, Twelfth

Edition, Prentice Hall.

Hughes, J. and MacDonald, S. (2002) International Banking, Addison Wesley.

Johanson, J. and Vahlne, J.E. (1977) „The internalization process of the firm--a model

knowledge development and increasing foreign market commitments‟, Journal of

International Business Studies, Vol. 8, No. 1, pp. 23-32.

Johanson, J. and Wiedersheim-Paul, F. (1975) „The internationalization of the firm: four

Swedish case studies‟, Journal of Management Studies, Vol. 12, No. 3, pp. 305-

322.

Madura, J. (2011) Financial Markets and Institutions, Ninth Edition, South-Western,

Cengage Learning.

Rose, P. and Hudgins, S. (2010) Bank Management and Financial Services, Eighth

Edition, McGraw-Hill Irwin.

Rugman, A.M. and Verbeke A. (2001) „Subsidiary-specific advantages in multinational

enterprises‟, Strategic Management Journal, Vol. 22, No.3, pp. 237-250.