1. CHAPTER FOURTEEN
DIRECT INVESTMENT AND
• To clarify why companies may need to use modes other than exporting to operate
effectively in international business
• To comprehend why and how companies make foreign direct investments
• To understand the major motives that guide managers when choosing a collaborative
arrangement for international business
• To define the major types of collaborative arrangements
• To describe what companies should consider when entering into arrangements with
• To grasp what makes collaborative arrangements succeed or fail
• To see how companies can manage diverse collaborative arrangements
Although most companies operating internationally would prefer exporting to other
market entry modes, there are circumstances in which exporting may not be feasible. In
these cases, companies may engage in direct investment in other countries, or enter
markets through various collaborative strategies such as joint ventures and alliances.
Collaborative strategies allow firms to spread both assets and risk across countries by
entering into contractual agreements with a variety of potential partners. Chapter
Fourteen first discusses reasons for not exporting and then explores the motives that drive
firms to engage in noncollaborative and collaborative arrangements, as well as the
various types of possible arrangements, including foreign direct investment, licensing,
franchising, joint ventures, and equity alliances. It goes on to explore the various
problems that may arise in FDI and collaborative ventures and concludes with a
discussion of the various methods for managing these evolving arrangements.
OPENING CASE: Cisco Systems
[See Map 14.1]
Globalization has pushed Cisco Systems into a broader range of markets in order to
follow the expansion patterns of its customers, solicit new business, and study new ideas
and products. Cisco’s worldwide alliances spur the company to continue learning and to
refine its competencies. They enable it to meet customer needs that fall outside its areas
of core competencies, while simultaneously permitting Cisco and its partners to enhance
2. their competitiveness by focusing on their respective competencies. Alliances have also
permitted Cisco to limit its capital outlays in potentially lucrative but risky ventures.
Cisco believes alliances improve its processes, reduce its costs and expose it to the best
competitive practices. The firm’s official Strategic Alliances Team manages crucial
partnerships with industry-leading technology and integrator firms, and it is the driving
force behind the collaborative development effort to accelerate new market opportunities.
Cisco has generally standardized the mechanics of partnership agreements. However, it
continues to work to improve the odds of collaborative success by better managing the
matters of trust, commitment and culture that shape what Cisco calls “interwoven
dependencies and relationships” with its partners.
Teaching Tip: Review the PowerPoint slides for Chapter Fourteen and select those
you find most useful for enhancing your lecture and class discussion. For additional
visual summaries of key chapter points, review the figures in the text.
When forming objectives and implementing strategies in a variety of country
environments, firms must either handle international business operations on their
own or collaborate with other companies (Figure 14.2). Although exporting is
usually the preferred alternative since it allows firms to produce in their home
countries, participating in some markets may require using a variety of other equity
and nonequity arrangements (Figure 14.3). These can range from wholly owned
operations to partially owned subsidiaries, joint ventures, equity alliances, licensing,
franchising, management contracts, and turnkey operations.
II. WHY EXPORTING MAY NOT BE FEASIBLE
Companies may find more advantages by producing in foreign countries rather than
by exporting to them due to a variety of reasons.
A. Cheaper to Produce Abroad
Competition requires companies to control their costs and to choose production
locations with this factor in mind.
B. Transportation Costs
Some products and services become impractical to export after the cost of
transportation is added to production costs. In general, the farther the target
market is from the home country, the higher the transportation costs. Also, the
higher transportation costs are relative to production costs, the more difficult it
is to be competitive through exporting. Some services are impossible to export
and require establishing operations in the target country.
C. Lack of Domestic Capacity
As long as a company has excess capacity, it can service foreign markets and
price on the basis of variable rather than full costs. When demand exceeds
capacity, however, new facilities are needed and are often located nearer to the
end consumers in other countries.
D. Need to Alter Products and Services
Special requirements for products in some markets may require additional
investments that are often better made in the country the company intends to sell
3. to. The more that products must be altered for foreign markets, the more likely
production will shift to those foreign markets.
E. Trade Restrictions
Although import barriers have been on the decline, some significant tariffs
continue to exist. In these situations, avoiding barriers through production in the
target country must be weighed against other considerations such as the market
size of the country and the scale of technology used in production. When
barriers fall within a group of countries, companies may be attracted to make
direct investments to serve the entire region since the expanded market may
justify scale economies.
F. Country of Origin Effects
Consumers may prefer goods produced in their own country over imports
because of nationalistic feelings. For some products, consumers may prefer
imported goods from specific countries due to a perception that those products
are superior. Other considerations like the availability of service and
replacement parts for imported products, or adoption of just-in-time
manufacturing systems may influence production locations.
III. NONCOLLABORATIVE FOREIGN EQUITY ARRANGEMENTS
Two forms of foreign direct investment (FDI) that do not involve collaboration are
wholly owned operations and partially owned operations with the remainder widely
A. Foreign Direct Investment and Control
To qualify as a foreign direct investment, the investor must have control. This
can be established with a small percentage of the holdings if ownership is
widely dispersed. The more ownership a company has, the greater its control
over the management decisions of the operation. There are three primary
reasons for companies to want a controlling interest—internalization theory,
appropriability theory, and freedom to pursue global objectives.
1. Internalization. Control through self-handling of operations is known as
internalization. Transactions cost theory holds that companies should
organize operations internally when the costs of doing so are lower than
contracting with another party to handle it for them. Internalization may
result in lower costs because:
• Different operating units with the same company likely share a
common culture which expedites communications
• The company can use its own managers who understand and are
committed to carrying out its objectives
• Negotiations that might delay the investment or complicate its
management can be avoided
• The company can avoid possible problems with enforcing an agreement
2. Appropriability. Appropriability theory is the idea that companies want
to deny rivals and potential rivals’ access to resources such as capital,
patents, trademarks, and management know-how that might be captured
through collaborative agreements.
4. 3. Pursuit of Global Strategies. When a company has a wholly owned
foreign operation, it may more easily have that operation participate in a
global or transnational strategy. Furthermore, the fact that most countries
have laws to protect minority shareholders’ interest means that sharing of
ownership may restrict a company from implementing a global or
B. Methods for Making FDI
FDI usually involves international capital movement, but could also involve the
transfer of other assets such as managers, cost control systems. Companies can
either acquire an interest in an existing company or construct new facilities,
known as a greenfield investment.
1. Reasons for Buying. Companies may acquire existing operations in
order to avoid adding further capacity to the market, to avoid start-up
problems, obtain easier financing, and get an immediate cash flow rather
than tying up funds during construction. A company may also save time,
reduce costs, and reduce risks by buying an existing company.
2. Reasons for Greenfield. Companies may choose to build if no suitable
company is available for acquisition, if the acquisition is likely to lead to
carry-over problems, and if the acquisition is harder to finance. In addition,
local governments may prevent acquisitions because they want more
competitors in the market and fear foreign domination.
II. MOTIVES FOR COLLABORATIVE ARRANGEMENTS
Each participant in a collaborative arrangement has its own basic objectives for
operating internationally as well as its own motives for collaborating with a partner.
A. Motives for Collaborative Arrangements: General
Companies collaborate with other firms in either their domestic or foreign
operations in order to spread and reduce costs, to specialize in particular
competencies, to avoid or counter competition, to secure vertical and/or
horizontal linkages and to learn from other companies.
1. Spread and Reduce Costs. When the volume of business is small,
or one partner has excess capacity, it may be less expensive to collaborate
with another firm. Nonetheless, the costs of negotiation and technology
transfer must not be overlooked.
2. Specialize in Competencies. The resource-based view of the firm
holds that each firm has a unique combination of competencies. Thus, a
firm can maximize its performance by concentrating on those activities that
best fit its competencies and relying on partners to supply other products,
services, or support activities.
3. Avoid or Counter Competition. When markets are not large
enough for numerous competitors, or when firms need to confront a market
leader, they may band together in ways to avoid competing with one
another or combine resources to increase their market presence.
4. Secure Vertical and Horizontal Links. If a firm lacks the
competence and/or resources to own and manage all of the activities of the
value-added chain, a collaborative arrangement may yield greater vertical
5. access and control. At the horizontal level, economies of scope in
distribution, a better smoothing of sales and earnings through diversification
and an ability to pursue projects too large for any single firm can all be
realized through collaboration.
5. Gain Knowledge. Many firms pursue collaborative arrangements in
order to learn about their partners’ technology, operating methods, or home
markets and thus broaden their own competencies and competitiveness over
B. International Motives for Collaborative Arrangements
Companies collaborate with other firms in their foreign operations in order to
gain location-specific assets, overcome legal constraints, diversify
geographically and minimize their exposure in high-risk environments.
1. Gain Location-Specific Assets. Cultural, political, competitive, and
economic differences among countries create challenges for companies that
operate abroad. To overcome such barriers and gain access to location-specific
assets (e.g., distribution access or a competent workforce), firms
may pursue collaborative arrangements.
2. Overcome Governmental Constraints. Countries may prohibit or
limit the participation of foreign firms in certain industries, or discriminate
against foreign firms via tax rates and profit repatriation. Firms may be able
to overcome such barriers via collaboration with a local partner.
3. Diversify Geographically. By operating in a variety of countries, a firm
can smooth its sales and earnings; collaborative arrangements may also
offer a faster initial means of entering multiple markets or establishing
multiple sources of supply.
4. Minimize Exposure in Risky Environments. The higher the risk
managers perceive with respect to a foreign operation, the greater their
desire to form a collaborative arrangement.
III. TYPES OF COLLABORATIVE ARRANGEMENTS
While collaborative arrangements allow for a greater spreading of assets across
countries, the various types of arrangements necessitate trade-offs among objectives.
Finding a desirable partner can be problematic. A firm has a wider choice of
operating forms and partners when there is less likelihood of competition and when it
has a desired, unique, difficult-to-duplicate resource.
A. Some Considerations in Collaborative Arrangements
Two critical variables that influence the choice of collaborative arrangement are
a firm’s desire for control over its foreign operations and its prior expansion into
1. Control. The loss of control over flexibility, revenues and competition
is a critical variable in the selection of forms of foreign operation. The more
a firm depends on collaborative arrangements, the more likely its control
will be lessened over decisions regarding quality, new product directions
and production expansion.
Should Countries Limit Foreign Control of Key Industries?
POINT: Countries should limit foreign control of key industries in order to protect their
economic and security interests, especially in key industries such as transportation, mass
media, and energy. History has shown that home governments have used powerful
foreign companies to influence policies in the countries where they operate, and that
foreign companies have used their home governments as instruments to improve their
interests in a country. Whenever a company is controlled from abroad, decisions about
that company can be made abroad, possibly to the detriment of the host country.
COUNTERPOINT: Decisions made by foreign companies are not likely to be
much different than decisions made by local companies. MNEs staff their foreign
subsidiaries mainly with nationals of the countries where they operate, and make
decisions based on a good deal of local advice. Their decisions have to adhere to
local laws and consider the views of suppliers and customers. Protection of
certain industries from foreign control could reduce competitiveness in those
industries and harm, rather than help, the local people. Those who argue for
limits are relying on the outdated dependencia theory, which holds that emerging
economies have practically no power in their dealings with MNEs. More recent
bargaining school theory states that the terms for a foreign investor’s operations
depend on how much the investor and host country need the other’s assets.
Countries and foreign companies need each other, and both will lose if limitations
are placed on foreign control.
2. Prior Expansion of the Company. If a firm already owns and
controls operations in a foreign country, the advantages of collaboration
may not be as attractive as otherwise.
Under a licensing agreement, a firm (the licensor) grants rights to intangible
property to another company (the licensee) to use in a specified geographic area
for a specified period of time; in exchange, the licensee ordinarily pays a royalty
to the licensor. Such rights may be exclusive or nonexclusive. Usually the
licensor is obliged to furnish technical information and assistance, while the
licensee is obliged to exploit the rights effectively and pay compensation to the
licensor. Intangible property may be classified as:
• patents, inventions, formulas, processes, designs, patterns
• copyrights for literary, musical, or artistic compositions
• trademarks, trade names, brand names
• franchises, licenses, contracts
• methods, programs, procedures, systems.
1. Major Motives for Licensing. Licensing often has an economic
motive, such as the desire for faster start-up, lower costs, or access to
additional property rights (e.g., technology). For the licensor, the risks and
7. costs of a given venture are lessened; for the licensee, costs are less than if it
had to develop a product or process on its own. Cross-licensing represents
the situation in which companies in various countries exchange technology
rather than compete with each other with every product in every market.
2. Payment. The amount and type of payment for licensing
arrangements may vary. Each contract tends to be negotiated on its own
merits; the bargaining range is based on dual expectations. Both agreement-specific
and environment-specific factors may affect the value of a license.
3. Sales to Controlled Entities. Many licenses are given to firms
owned in part or in whole by the licensor. From a legal standpoint,
subsidiaries are separate companies; thus, a license may be required in order
to transfer intangible property.
Franchising represents a specialized form of licensing in which the franchisor
not only sells an independent franchisee the use of the intangible property
essential to the franchisee’s business, but also operationally assists the business
on a continuing basis. In a sense, the two partners act like a vertically integrated
firm because they are interdependent and each produces a part of the product
that ultimately reaches the customer.
1. Organization of Franchising. A franchisor may penetrate a foreign
country by dealing directly with its foreign franchisees, or by setting up a
master franchise and giving that organization the right to open outlets on its
own or to develop sub-franchises in the country or region.
2. Operational Modifications. Franchise success is derived from three
factors: product standardization, effective cost control and high recognition.
Nonetheless, franchisors face a classic dilemma: the more they standardize
on a global basis, the lower the potential for product acceptance in a given
country; the more they permit adaptation to local conditions, the less the
franchisor can offer the franchisee, the higher the costs and the less the
control by the franchisor.
D. Management Contracts
A management contract represents an arrangement in which one firm provides
management personnel to perform general or specialized functions to another
firm for a fee. A firm usually pursues such contracts when it believes a partner
can manage certain operations more efficiently and effectively than it can itself.
E. Turnkey Operations
Turnkey operations represent a type of collaborative arrangement in which one
firm contracts with another to build complete, ready-to-operate facilities.
Usually, suppliers of turnkey facilities are industrial-equipment and construction
companies; projects may cost billions of dollars; customers most often are
government agencies or large MNEs.
F. Joint Ventures
A joint venture represents a direct investment in which two or more partners
share ownership. As a firm’s share of the equity declines, its ability to control a
given operation also declines. A consortium represents the joining together of
several entities (e.g., companies and governments) to combine resources and/or
8. to strengthen the possibility of pursuing a major undertaking. Other forms of
joint ventures include:
• Two companies from the same country joining together in a foreign market,
such as NEC and Mitsubishi (Japan) in the United Kingdom
• A foreign company joining with a local company, such as Great Lakes
Chemical (U.S.) and A. H. Al Zamil in Saudi Arabia
• Companies from two or more countries establishing a joint venture in a
third country, such as that of Diamond Shamrock (U.S.) and Sol Petroleo
(Argentina) in Bolivia
• A private company and a local government forming a joint venture
(sometimes called a mixed venture), such as that of Philips (Dutch) with the
• A private company joining a government-owned company in a third
country, such as BP Amoco (private British-U.S.) and Eni (government-owned
Italian) in Egypt
G. Equity Alliances
An equity alliance represents a collaborative arrangement in which at least one
of the collaborating firms takes an ownership position (usually a minority) in the
other(s). The purpose of an equity alliance is to solidify a collaborating contract,
thus making it more difficult to break.
IV. PROBLEMS OF COLLABORATIVE ARRANGEMENTS
Dissatisfaction with the results of collaboration can cause an arrangement to break
down. Problems arise for a number of reasons.
A. Collaboration’s Importance to Partners
One partner may give more attention to the collaboration than the other—often
because of a difference in size. An active partner will blame the less active
partner for its lack of attention, while the less active partner will blame the other
for poor decisions.
B. Differing Objectives
Although firms may enter into collaborative arrangements with complementary
capabilities and objectives, their views regarding such things as reinvestment vs.
profit repatriation and desirable performance standards may evolve quite
differently over time.
C. Control Problems
When no single party has control of a collaborative arrangement, the venture
may lack direction; if one party dominates, it must still consider the interests of
the other. By sharing assets with another firm, a company may lose some control
over the extent and/or quality of the assets’ use. Further, even when control is
ceded to one of the partners, both may be held responsible for problems.
D. Partners’ Contributions and Appropriations
One partner’s ability to contribute technology, capital and other assets may
diminish (at least on a relative basis) over time. Further, in almost all
collaborations the danger exists that one partner will use the others’ contributed
assets, or take more than its fair share from the operation, thus enabling it to
9. become a direct competitor. Such weaknesses may cause a drag on a venture and
even lead to the dissolution of the agreement.
E. Differences in Culture
Differences in both national and corporate cultures may cause problems with
collaborative arrangements, especially joint ventures. Firms differ by nationality
in terms of how they evaluate the success of an operation (e.g., profitability,
strategic market position and/or social objectives). Nonetheless, joint ventures
from culturally distant countries tend to survive at least as well as those between
partners from similar cultures.
V. MANAGING FOREIGN ARRANGEMENTS
As a collaborative arrangement evolves, partners need to reassess certain decisions in
light of their resource bases and external environmental changes.
A. Dynamics of Collaborative Arrangements
The evolutionary costs of a firm’s foreign operations may be very high as it
switches from one operational mode to another, especially if it must pay
termination fees. Thus, a firm must develop the means to evaluate performance
by separating the controllable and uncontrollable factors at its various profit
B. Finding Compatible Partners
A firm may actively seek a partner for its foreign operations, or it can react to a
proposal from another company to collaborate with it. Potential partners should
be evaluated both for the resources they can offer and their willingness to work
together. The proven ability to handle similar types of collaboration is a key
C. Negotiating Process
Certain technology transfer considerations are unique to collaborative
arrangements; often pre-agreements are set up to protect concerned parties. The
secrecy of financial terms, especially when government authorities consult their
counterparts in other countries, is an especially sensitive area. Market conditions
may dictate the need for different terms in different countries.
D. Contractual Provisions
To minimize potential points of disagreement, contract provisions should
address the following factors:
• Terminating the agreement if the parties do not adhere to the directives
• Methods of testing for quality
• Geographical limitations on the asset’s use
• Which company will manage which parts of the operation outlined to the
• What each company’s future commitments will be
• How each company will buy from, sell to, or use intangible assets that come
from the collaborative arrangement
E. Performance Assessment
All parties should establish mutual goals so all involved understand what is
expected, and a contract should spell out expectations. In addition to the
10. continuing assessment of the venture’s performance, a firm should also
periodically assess the possible need for a change in the type of collaboration.
LOOKING TO THE FUTURE:
Why Innovation Breeds Collaboration
Because the cost of invention is often so high, it follows that firms of considerable size
will carry out most innovation. Although firms can become ever larger through mergers
and acquisitions, collaborative arrangements are likely to be increasingly important in the
future as governments opt to restrict such activities because of antitrust concerns. At the
same time, collaborative arrangements will bring forth both opportunities and problems
as firms move simultaneously into new countries and to new types of contractual
arrangements with new partners. The more partners in a given alliance, the more strained
the decision-making and control processes will likely be.
CLOSING CASE: International Airline Alliances [See Map 14.2]
Most of the world’s airlines have formed alliances with other airlines covering
things such as combined routes, sales, airline terminal services, and frequent
flier programs. In addition, many airlines hold an ownership position in other
airlines. Much of this cooperative activity is driven by government regulations
that limit foreign participation in domestic markets, making alliances the only
practical alternative to increasing breadth of service. Other factors such as cost
savings and intense competition have also led to the formation of alliances.
1. Discuss a question raised by the manager of route strategy at American Airlines:
Why should an airline not be able to establish service anywhere in the world simply
by demonstrating that it can and will comply with the local labor and business laws
of the host country?
When considering either the international or simply the domestic environment, a
major consideration is whether economic interests in the airline industry are better
served through regulation via the market. Proponents of deregulation argue that
competition has forced carriers to become efficient or else go out of business, instead
of being subsidized by regulated route and fare structures. Proponents also argue that
the survival of mega-carriers leads to economies of scale in handling passengers and
cargo. Opponents argue that local interests are often ill-served by deregulation since
11. airlines are free to discontinue service and to wage predatory price wars that put
competitors out of business, at which point the survivors will then raise prices.
Opponents also raise fears there may eventually be too few survivors to allow for the
competition that was envisioned by the proponents of deregulation; the high barriers
to entry in the industry further exacerbate this situation. Another major consideration
deals with the political dimensions of the question. Because most governments see
airlines as a key national industry, they oppose giving foreign carriers access to
domestic routes on grounds of both national security and consumer welfare.
2. The president of Japan Air Lines has claimed that U.S. airlines are dumping air
services on routes between the United States and Europe, meaning they are selling
below their costs because of the money they are losing. Should governments set
prices so that carriers make money on routes?
It is very difficult to separate profits and losses on a route-by-route basis. While fares
and loads on certain routes may seem to be low, they may in fact be generating
marginal revenues that make major routes profitable. A second issue is that of price
elasticity. If governments were to set prices above the equilibrium point, traffic and
revenues, and hence profitability, would all fall. A third issue is that of ownership. If
privately owned carriers abandon routes to government-owned airlines, they could
well give advantages to those airlines that could then be used against them on other
routes. Finally, the issue of profitability raises the question of subsidies. It is nearly
impossible to determine whether dumping is taking place when competitors receive
so many direct and indirect subsidies.
3. What will be the consequences if a few large airlines or networks come to dominate
global air service?
The consequences would be both positive and negative. On the positive side,
passengers should be able to travel almost anywhere in the world on a single airline
(or network). That in turn should minimize the risk of missed connections and lost
baggage. Operating economies should be realized as a result of the higher utilization
of airport gates and ground equipment—consequent savings may or may not be
passed along to passengers through lower prices. On the negative side, it is quite
possible that minimal competition would lead to poor service and/or high prices. In
addition, competition among the destinations associated with particular airlines
would likely decline, as would the special services offered by the “niche” airlines.
4. Some airlines, such as Southwest and Alaska Air, have survived as niche players
without going international or developing alliances with international airlines. Can
they continue this strategy?
When there is sufficient traffic on the city pairs that a route serves, there is little need
to have feeder or connecting routes for an airline to be profitable. In fact, without the
need for hubs to make connections, some airlines can operate in smaller but closer-to-
downtown airports, such as Midway in Chicago or La Guardia in New York. They
can avoid the costs associated with the transfer of bags to connecting flights and the
payment of overnight expenses to passengers who miss connections. In addition,
they may be able to overcome any disadvantages from small-scale operations by
12. targeting their promotion to regional and niche groups and by running low-cost
operations that charge low fares. Conventional wisdom would suggest they can in
fact survive in their present operational mode and that attempts to expand and/or
modify their operations might make them more, rather than less, vulnerable.
Teaching Tip: Visit www.prenhall.com/daniels for additional information and
links relating to the topics presented in Chapter Fourteen. Be sure to refer your
students to the on-line study guide, as well as the Internet exercises for Chapter
internalization, p. 489
appropriability theory, p. 489
resource-based view, p. 492
dependencia theory, p. 496
bargaining school theory, p. 496
consortium, p. 502
ADDITIONAL EXERCISES: Collaborative Strategies
Exercise 14.1. Ask the students to identify several foreign owned companies with
operations in their local area. Are these companies viewed as good corporate
citizens and contributors to the local community? Do they employ mostly local
people or do they have a large number of expatriates? How do the wages paid by
these companies compare to those of other companies in the same industry?
Exercise 14.2. Assume that a company near you wanted to expand into foreign
markets. What issues should that company explore before deciding whether to
export or to engage in foreign direct investment?
Exercise 14.1. Ask students to name companies, both domestic and foreign, that
operate internationally. Then ask them to discuss the potential types of collaborative
arrangements they feel would be appropriate for the various firms. Conclude the
discussion by examining the list of firms and asking students if there are particular
industries that seem to lend themselves to particular types of collaborative
arrangements more readily than others. Be sure the students discuss why this might
13. Exercise 14.2. Identify the various home countries of students in your class. Then
lead the class in a discussion of the likely types of collaborative arrangements
foreign firms might pursue in those countries. Be sure students cite the various
economic, political and cultural factors that would influence decisions regarding
viable collaborative strategies.
Exercise 14.3. While offering desirable advantages, licensing agreements also limit
the amount of control a licensor can exercise over a foreign production process.
Engage the students in a discussion of the type of firm that would most likely be
willing to allow a licensee to use its established brand name, and the type of firm that
would not be willing to do so. Explore the reasons for each position as well as the
reasons a licensee would be willing to accept a license that did not include rights to
the use of the associated brand name.