Dr. Victor Z. Chen UNC Charlotte Lecture 6 Dr. Victor Z. Chen UNC Charlotte

Internalization Benefits: Export/License/Franchise or FDI? Benefits of integration in general Additional benefits of international integration Additional Benefits International integration Synergies Integration benefits without synergies Integration in general

Part 1. Integration benefits without synergies

JV/merger to compete Compare combined strength in each O advantage item with competitors. Combined Os > Os of existing competitors

O advantages: WF vs. Top5 Ideal JV partner: 1. Only competitors that are lower in some Os would be willing to JV/Merger with WFC 2. Try hypothetical JV/merger with each of the willing competitor 3a. For additive Os, the after JV/merger O value would be the sum of both firms 3b. For non-additive Os (ratios), the after JV/merger O value would be between both firms (approximately the mean value if two firms are of similar sizes) 4. The ideal partner is the one with which the after JV/merger O values are higher than all other remaining competitors. Company Name No. of employees (k) Total Assets (US$B) ROA % ROE % Total Asset Turnover # of Key Executives with International Work Experience # of Foreign Subsidiaries # of Countries of Foreign Subsidiaries Bank of America Corp. (BAC) 208.00 2187.70 0.82 6.83 0.040 2 100 28 Citigroup Inc (C ) 219.00 1792.08 0.84 6.65 0.050 4 108 30 Goldman Sachs Group Inc (GS) 34.40 860.17 0.86 8.50 79 10 JPMorgan Chase & Co (JPM) 243.36 2490.97 1.02 9.83 39 7 Morgan Stanley (MS) 55.31 814.95 0.74 7.89 5 38 Wells Fargo & Co. (WFC) 269.10 1930.12 1.18 11.15 80

Whom to merge/JV with? Total assets ($ billion) Return on assets (ROA) (%) Competitor 1 5 20 Competitor 2 8 15 Your company 10 Your goal: Increase in total assets, and highest ROA in the industry. ROA=net income/total assets So: net income = total assets x ROA Merged/JV net income= ∑ net income of each member Merged/JV total assets = ∑ total assets Merged/JV ROA = Merged/JV net income / Merged/JV total assets

Part 2. Synergies

A typical value chain curve Source: http://www.brookings.edu/~/media/events/2010/6/09%20china%20global/20100609_ china_global_steinfield.pdf

Three Directions of Integration Backward integration: the ownership of equity assets used earlier in the production cycle, such as an auto firm that acquires a steel company. Forward integration: the purchase of assets or facilities that move the company closer to the customer such as a computer manufacturer that acquires a retail chain, which specializes in computer products. Horizontal integration: the purchase of firms in the same line of business such as a computer chip firm, which acquires a competitor. Vertical integration

Three Directions of Integration A resource-based view Suppliers Raw materials and intermediate goods providers, designers, technology providers, etc. Industry Manufacturing & Production Customers Wholesalers & Retailers backward horizontal forward

High-margin vs. low-margin value chain curves

Integration synergies: Three ways Moving up in the value chain Economies of scale Economies of scope (e.g., to ensure standard quality) A value-chain-based view

What was the motivation behind this?

Part 3. Additional Integration Benefits across Borders Market failure Tax advantages (No market failure)

1. Market Failure: Hierarchy vs. Market

Institutional advantages: Market failure / Tax Select Measures of Market-Supporting Institutions Category Specific examples US Hong Kong SAR China Mainland Strong property rights Registration of private property (days, % of property value) Legal protection of private property (1-10, 10 best) Investor protection (1-10, 10 best) Intellectual property rights (IPR) protection (1-7, 7 best) 15.1, 2.1% 7.2 8.3 5.4 27.5, 7.7% 8.4 9.0 5.8 19.5, 3.4% 5.0 4.0 Free and fair competition Easy entry Low government consumption (1-10, 10 best) Low government enterprises/investments (1-10, 10 best) Low corporate tax Low other taxes and fees No informal competition 5.6 days 6.4 8.0 40% 4% Very low 1.5 days 8.1 10.0 16.5% 6.5% 31 days 3.7 2.0 25% 43% 57.6% Low transaction cost Credit (% of adults covered by credit bureau; depth of information) Strong auditing/reporting standards (1-7, 7 best) Low trading barriers (hours) Free trade agreements Bilateral investment treaties Freedom of migration 100%, 8.0 5.5 7 None with HK or China No visa to HK, needs visa to China 96%, 7.0 6.2 20 With China No visa to China or US 0%, 7.0 4.4 103 With HK No visa to HK, needs visa to US Strong contract enforcement High corporate ethics Legal resolution of contract claims (days, cost as % of claim) 4.8 420 days, 31% 360 days, 21% 4.2 453 days, 16%

Round-tripping and transshipment FDI Round-tripping FDI Company X(A) makes an initial investment from country A to country B to set up a new subsidiary X(B), which makes further investment (with or without new capital) back into country A as a country B foreign investor. Transshipment FDI Company X(A) makes an initial investment from country A to country B to set up a new subsidiary X(B), which makes further investment (with or without new capital) into country C as a country B foreign investor.

Trans-shipment For instance, in 2011, Sinopec, China’s largest oil refiner, acquired 30% of Galp Energia (Brazil) for $5.2 billion, but indirectly through its Hong Kong subsidiary, Sinopec International Petroleum Exploration and Development Corp (SIPC).

An idea for a special market of clients Rather than directly serving US- China two-way FDI players as an M&A advisor, why not start by approaching US- HK-China three- way transshipment FDI players?

1. Market Failure: Hierarchy vs. Market Select Measures of Market-Supporting Institutions Category Specific examples US Hong Kong SAR China Mainland Strong property rights Registration of private property (days, % of property value) Legal protection of private property (1-10, 10 best) Investor protection (1-10, 10 best) Intellectual property rights (IPR) protection (1-7, 7 best) 15.1, 2.1% 7.2 8.3 5.4 27.5, 7.7% 8.4 9.0 5.8 19.5, 3.4% 5.0 4.0 Free and fair competition Easy entry Low government consumption (1-10, 10 best) Low government enterprises/investments (1-10, 10 best) Low corporate tax Low other taxes and fees No informal competition 5.6 days 6.4 8.0 40% 4% Very low 1.5 days 8.1 10.0 16.5% 6.5% 31 days 3.7 2.0 25% 43% 57.6% Low transaction cost Credit (% of adults covered by credit bureau; depth of information) Strong auditing/reporting standards (1-7, 7 best) Low trading barriers (hours) Free trade agreements Bilateral investment treaties Freedom of migration 100%, 8.0 5.5 7 None with HK or China No visa to HK, needs visa to China 96%, 7.0 6.2 20 With China No visa to China or US 0%, 7.0 4.4 103 With HK No visa to HK, needs visa to US Strong contract enforcement High corporate ethics Legal resolution of contract claims (days, cost as % of claim) 4.8 420 days, 31% 360 days, 21% 4.2 453 days, 16%

2. Tax Advantages (No Market Failure) Now compare the quality of market institutions among US, China (mainland), and HK. Do you control your operations in HK or trade with someone local? Think from Hierarchy vs. Market A focus on tax advantages

A transaction between two independent firms (in US and China) Hong Kong SAR China Sales US$ 8 million (market) ? US$ 10 million Costs of sales US$ 5 million Profit Corporate tax rate 40% 16.5% 25% Net profit If you sell your goods/services from US to China following the open international market price (US$8 million), how much would be the total net profit?

In which country would your profit be made eventually? A transaction between two subsidiaries (in US and China) of the same Multinational Enterprise (via internal transfer) US Hong Kong SAR China Sales ? (intra-firm) ? US$ 10 million Costs of sales US$ 5 million Profit Corporate tax rate 40% 16.5% 25% Net profit How would you price intra-firm exports of intermediate goods/services from the US to China? (fill these question marks) to maximize the total net profits? In which country would your profit be made eventually? How much would be the maximal total net profit?

In which country would your profit be made eventually? A transaction between two subsidiaries (in US and China) of the same Multinational Enterprise through a profit settlement center in Hong Kong SAR Q4 US Hong Kong SAR China Sales ? (intra-firm) US$ 10 million Costs of sales US$ 5 million Profit ? Corporate tax rate 40% 16.5% 25% Net profit How would you price intra-firm exports of intermediate goods/services from the US to China via your HK subsidiary ? (fill these question marks) In which country would your profit be made eventually? How much would be the maximal total net profit?

Internalization Benefits Integration benefits in general Move up the value chain Backward: Higher knowledge intensity Forward: Higher customer market control Horizontal: Economy of scale Additional integration benefits across borders Addressing market failure: Organizational costs < market costs Tax advantages: Internal transfer

Contact Victor Z. Chen Belk College of Business UNC Charlotte +1 (704) 687-7645 zchen23@uncc.edu www.ChenZitian.com