Bertos Manufacturing Corporation (BMC) is one of the largest companies of the country in the manufacturing of construction and mining equipment, and engines.    This case deals with the key considera

FOREIGN DIRECT INVESTMENT OPTIONS

Bertos Manufacturing Corporation

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 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 its international presence further through entry into additional markets. Ten candidate countries are being considered to determine the five most suitable for entry. A supplementary consideration is the mode of direct investment in the selected markets. Hence the need for a rational decision on where to invest and what form should this investment take.

Keywords: Subsidiaries; multinational enterprise; transnational activities; foreign direct investment; greenfield investment; leveraged institution; wholesale financing; captive finance company; retail instalment 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 finance companies. He went on to state that she needed to also address the mode of direct investment in these foreign markets--a joint venture (shared ownership) with a local partner versus a wholly owned subsidiary established through purchase of an existing company or through a greenfield investment (from the ground up, that is, from a green field). 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 in 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 selection and entry mode determination.

1. Internationalization Process

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. Some firms

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.

1. 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, 2002).

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. Despite the advantages of wholly-owned foreign subsidiaries, certain countries require a joint venture with a compatible local partner to secure access to the host-country’s capital markets. Whatever their organizational form, foreign finance companies are heavy users of debt in financing their local operations. Just as in the United States, their principal sources of borrowed funds include bank credits and issues of debt (e.g., bonds) 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 businessoriented financial services including working capital loans, revolving credit and equipment lease financing.

1. 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.

1. 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 instalment 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 wholly-owned 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 in 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.

1. Developing Criteria for Country Selection and Entry Mode Determination

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

To complete her assignment Victoria also needed to address the company’s mode of direct investment in the selected countries, and advance the arguments in support of her recommendation. To this end she felt essential to first identify the major advantages and disadvantages associated with each form of foreign direct investment before any recommendation on the mode of entry. Available literature on the subsidiary form of organization identifies a number of major advantages for the parent institution, e.g., a separate legal entity which, organized under the laws and regulated by the authorities of the host country, may function as a full service institution in its home market; and protection for the parent company since any losses sustained are limited to the amount of capital invested.. The primary disadvantage of a subsidiary is that it must be separately capitalized from the parent and as such it requires a sizable start-up investment. By the same token, a joint venture is associated with a number of advantages and disadvantages for the parent firm. Partial ownership of a foreign business includes such advantages as a local partner that understands host country customs, mores and institutions, availability of partner’s competent management, contacts and reputation that enhance access to local capital markets, and possession of technology appropriate for the local environment or perhaps foreign markets. Potential conflicts or difficulties associated with a joint venture include a government overthrow that may render the local partner a political liability, divergent policy views or interference of the local partner in certain critical decisions at the parent company level, disclosure of operating results and financial positions offering non-disclosing local firms a competitive advantage, and valuation of partner’s equity shares for contributed technology or other resources. The latter is a decisive issue in a country where such resources may be stateowned.

Choice between a greenfield investment and a cross-border acquisition may be a matter of such considerations as structural specifications, expediency, and cost. Although a greenfield investment offers the opportunity to build to company’s own specifications, it is susceptible to delays and cost overruns. Acquisition, on the other hand, is the most expeditious way to enter new markets and expand operations geographically. Also, it may entail a lower cost--it is often more economical to acquire a going concern with the desired expertise and an established market than to build such expertise from scratch, recruit the necessary personnel, promote it, and operate it profitably.

1. Assignment

1. Identify the key criteria and considerations that need to be taken into account in evaluating BFSI entry in the proposed foreign markets.

1. Of the countries under consideration, which five would be most suitable for the immediate establishment of a BFSI company? Highlight the key issues for each of the selected countries and discuss the reasoning behind your recommendation.

1. Which countries would be unsuitable for a BFSI company at this time, and what are the basic shortcomings in each case?

1. What is the recommended mode of entry in the selected countries and what are the key considerations in support of this recommendation?

Table 1 Financial highlights of BMC

Total revenues $44.9

Profit after taxes 3.5

Assets 56.1

Stockholders’ equity 8.9

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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

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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