FIN3034: International Financial Management

Tutorial 2

1. Competitive Advantage. When firms decide to invest in foreign countries, their decision
is based on the competitive advantage of the firm as well as those of the host country.
What are some of competitive advantages enjoyed by both the firms and host nations?
The competitive advantages enjoyed by MNEs include:
• economies of scale and scope,
• managerial skills,
• marketing expertise,
• technology,
• financial competitiveness, and
• differentiated products.
The competitive advantages of host nations include:
• cheap and abundant factors of production,
• favourable domestic market conditions,
• an abundance of suppliers, and
• a sound investment environment.

A competitive advantage enables a company to perform better than its competitors. It

refers to factors allowing a company to produce services or goods better or for less expense
than the competition, which may generate more sales or higher profit margins.

Businesses use both competitive advantage and comparative advantage to find ways to
amplify sales and maintain their customer base. They differ from one another in causation
and methods used.

Competitive advantage: For example, businesses want to find a way to set themselves apart
from other businesses, or to develop a unique image, unlike others in their industry, to
establish a loyal customer base.

Comparative advantage: a result of economies of scale via a larger scale of production,

allowing businesses to produce and sell a larger quantity of products at a lower market price.

Another way to highlight the difference between competitive and comparative advantage is
that businesses with competitive advantage don't necessarily need to rely on price. In
contrast, a business using comparative advantage seeks to reduce costs as much as possible
while maintaining quality standards. This allows them to compete with competitors by
offering a lower market price.

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2. Licensing and Management Contracts Versus Producing Abroad. What are the
advantages and disadvantages of licensing and management contracts compared to
producing abroad?
Licensing is a popular method for domestic firms to profit from foreign markets without
the need to commit sizable funds. Since the foreign producer is typically wholly owned
locally, political risk is minimized. In recent years a number of host countries have
demanded that MNEs sell their services in “unbundled form” rather than only through
FDI. Such countries would like their local firms to purchase managerial expertise and
knowledge of product and factor markets through management contracts, and purchase
technology through licensing agreements.
The main disadvantage of licensing is that license fees are likely to be lower than FDI
profits, although the return on the marginal investment might be higher. Other
disadvantages include:
▪ Possible loss of quality control
▪ Establishment of a potential competitor in third-country markets
▪ Possible improvement of the technology by the local licensee, which then enters the
original firm’s home market
▪ Possible loss of opportunity to enter the licensee’s market with FDI later
▪ Risk that technology will be stolen
▪ High agency costs
MNEs have not typically used licensing of independent firms. On the contrary, most
licensing arrangements have been with their own foreign subsidiaries or joint ventures.
License fees are a way to spread the corporate research and development cost among all
operating units and a means of repatriating profits in a form more acceptable to some host
countries than dividends.
Management contracts are similar to licensing insofar as they provide for some cash flow
from a foreign source without significant foreign investment or exposure. Management
contracts probably lessen political risk because repatriation of managers is easy.
International consulting and engineering firms traditionally conduct their foreign business
on the basis of a management contract.
Whether licensing and management contracts are cost effective compared to FDI depends
on the price host countries will pay for the unbundled services. If the price were high
enough, many firms would prefer to take advantage of market imperfections in an
unbundled way, particularly in view of the lower political, foreign exchange, and business
risks. Because we observe MNEs continuing to prefer FDI, we must assume that the price
for selling unbundled services is still too low.

3. Blocked Funds. Why do MNEs operate in countries that impose transfer restrictions and
how can they manage impending transfer risks?
Among the political risks that MNEs face are the risks that the governments of these
nations can pass unexpected laws or take measures that prohibit or limit the remittance of
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 revenues abroad. Prior to forming a subsidiary or a joint venture, MNEs have to carefully
assess:
1. the foreign exchange situation in the host country,
2. the balance-of-payments situation,
3. the amount of reserves.
4. various accessible alternatives that it can use to ease blocked funds.

4. Sovereign Credit Risk. Is sovereign credit risk an example of a micro or macro risk? How
can it impact MNEs?
Sovereign credit risk arises when a borrower country becomes unable or unwilling to fulfill
its sovereign debt obligations, whether those of principal amount payments and/or interest
payments. Many developing countries faced such risks in the 1990s and several European
nations faced sovereign risk crises in the wake of the global financial crisis. Sovereign
credit risk is a country-specific risk. MNEs should take extra precaution when deciding to
invest or form joint ventures in such countries. Sovereign risk or default could lead to a
credit crunch in the nation, causing financing difficulties, lowering sales, and increasing
the possibility of default by government agencies. Sovereign credit ratings are prepared by
rating agencies to provide insight into the level of sovereign risk.