The use of real option reasoning in international market entry decisions

Thesis (M.A.), 2012

94 Pages, Grade: 1,0


Table of Contents

List of Abbreviations

List of Figures

List of Tables

1. Introduction

2. Firm-level effects of international expansion
2.1 Motives and constraints of internationalization
2.2 Views on the relationship between international expansion and firm performance
2.3 Common findings: The S-curve hypothesis

3. Real option theory and its contribution to the field of strategic management
3.1 Financial option theory
3.1.1 Synthetic option profit streams
3.2 Real option theory & real option reasoning
3.2.1 Basic principle and benefits
3.2.2 Conditions for applicability
3.2.3 Relevance of failure & learning in real option reasoning
3.2.4 Relevance of timing & flexibility in real option reasoning
3.2.5 Relevance of capabilities in real option reasoning

4. Application of real option reasoning on international market entry decisions
4.1 Differing attributes of market entry types from a ROR perspective
4.2 Attribute characteristics in acquisitions
4.3 Attribute characteristics in greenfield investment
4.4 Attribute characteristics in joint ventures
4.5 Attribute characteristics in franchising
4.6 Attribute characteristics in exporting/ licensing
4.7 Discussion

5. Conclusion

6. Appendix
6.1 Regression analyses of firm performance on internationalization in 1,489 Japanese Firms between 1986-1997
6.2 Examples of the Unintended Consequences of an Antifailure Bias
6.3 The Role of Time, Uncertainty, and Choice in Stepping Stone Options
6.4 English Summary
6.5 German Summary

7. Bibliography and references

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1: The Diminishing Returns Model of Multinationality

Figure 2: Interaction Effect of Product and International Diversification on ROA

Figure 3: The Role of Type of Expansion (Culturally Related/ Unrelated)

Figure 4: Multinationality and Performance: A Three-Phase Model

Figure 5: Profit Stream from Holding a Financial Option

Figure 6: The bull spread (Call options) and the bear spread (Put options)

Figure 7: The butterfly spread

Figure 8: The straddle combination

Figure 9: The strangle combination

Figure 10: Boundaries of Applicability for Net Present Value and Real Options

Figure 11: Timing of Exercise to Acquire Joint Ventures

Figure 12: Market entry depending on learning distance and exogenous uncertainty - Acquisitions

Figure 13: Market entry depending on learning distance and exogenous uncertainty - Greenfield investments

Figure 14: Market entry depending on learning distance and exogenous uncertainty - Joint ventures

Figure 15: Market entry depending on learning distance and exogenous uncertainty - Franchising

Figure 16: Market entry depending on learning distance and exogenous uncertainty - Exporting/ licensing

Figure 17: Market entry depending on learning distance and exogenous uncertainty

List of Tables

Table 1: Effects of changes in different variables on the price of a stock option

Table 2: “Option Traps” that hinder the abandonment of opportunities

Table 3: Two Concepts of the Corporation: SBU or Core Competence

1. Introduction

Traditional theories of strategic business development emphasize the negative effects of uncertainty, manifested in downside risks. Real option reasoning however highlights the positive as well as negative effects resulting from international expansion. In a business environment in which “between 1992 and 2007, the total flow of foreign direct investment from all countries increased by more than 500%, while world trade value grew 145% and world output by about 40%”1, but in the same time global expansion introduces severe risks on the firm-level, an incorporation of uncertainty in strategic decision heuristics seems to be inevitable.

This paper will take two streams of scholarly interaction into consideration, the internationalization theory and the real option theory. Both will be separately analyzed concerning their recent development and findings. For internationalization theory, this will basically include the discussion of benefits and constraints of an overall as well as marginal increase in a firm’s degree of internationalization. One focus will be on the inherent counter-effective forces in a framework of multinationality’s influence on firm performance. Another focus will be the discussion of influenceable firm- and employee- level roots of such effects and recommendations for their positive change.

Afterwards the idea of real option reasoning will be presented in detail. Therefore the understanding of its development starting at financial option theory is imperative. As will be presented, an evolutionary process of what is to be understood as a real option and its reasoning has taken place. This paper will therefore highlight different scholarly contributions to the field of real options theory and categorize their treatments of such approach into four differing conceptual definitions of real option thinking. Based on the understanding of real option reasoning as a strategy heuristic, the conditions for its applicability and the relevancy of diverse influences will be discussed. Especially the importance of flexibility, capabilities and uncertainty in this concept will be carved out. After both streams have been enlightened separately, they will be combined in one single concept for the application of real option reasoning in international market entry decisions. Therein as a first step, criteria for differentiating the diverse strategies for international market entry from a real option perspective will be developed. These criteria are not supposed to replace existing theories, but to add a constructive view on uncertainty to the strategic management discussion. Once the framework has been constructed, different forms of market entry will be analyzed concerning their attribute characteristics. In the end, a graphical representation of different market characteristics and the most promising form of market entry in these environments from a real option perspective shall be developed.

This paper is aiming for achieving three targets. At first, a common understanding of the complex forces in international market entries and the application of real option reasoning shall be shaped. As will be shown, this requires understanding of economical, financial as well as psychological underlying processes. Secondly, a solid decision framework for incorporating a beneficial view on uncertainty into strategic considerations shall be constructed. The key elements for doing so have already been set by Prahalad and Hamel, but need to be incorporated into the most recent global context, as will be shown. At third, this paper might function as a starting point for triggering additional scholarly research concerning the beneficial use of real option thinking in today’s international business environment.

2. Firm-level effects of international expansion

The globalization of firm’s operations, including sourcing as well as distribution of products and services, is not any more to be termed a trend, but a characteristic by now. This is observable in firms’ and consumers’ daily operations, where the global availability of certain products or services is taken for granted. It is for example justified in the reach of local, country- or continent-wide negative developments, which become a global threat. The most recent issues concerning the stability of the Euro currency are for example not only influencing companies and entrepreneurs in this specific area, but almost all other countries’ firms.

Hence the question of firm-level effects of international expansion arises. It has already been addressed in numerous scientific contributions dating from Raymond Vernon’s evolutionary product cycle model in 1966 until the presence.

This chapter will summarize major motives and constraints of international expansion. Along with the development of models analyzing the relationship between international expansion and firm performance, especially the counteracting effects between benefits and costs will be discussed in detail.

2.1 Motives and constraints of internationalization

For discussing the major motives of internationalization, the differentiation between exploitation and exploration benefits, applied by Lu and Beamish2, will be leveraged. Closely related to the early findings of Rugman3, benefits of the first type mainly result from the exploitation of foreign market opportunities and imperfections. With deciding to operate internationally, firms consequently decide to expand their market. The additional demand can be used for selling the domestically developed products and services to a wider range of customers. This is especially promising in foreign countries, in which “indigenous competitors in the nations a company enters lack comparable products”4 or equivalent distinctive competencies. In foreign markets, which are geographically close to the firm’s domestic market, the home base skills and managerial as well as administrative competencies can be leveraged without adaptation due to the high market familiarity5, i.e. a high geographic and cultural proximity. This being given, “relatively similar administrative mechanisms, similar consumer tastes and distribution systems compared to culturally and/or geographically distant locations”6 can be presumed.

The sales increase resulting from the international expansion will enable the realization of economies of scale, based upon several sources7. First of all might a product’s initial fixed costs, e.g. for R&D as well as for setting-up production facilities, be spread over the increased number of sold products. This will lower the average unit costs. The higher volume might as well lead to a better utilization of already existing production facilities, when capacities were not being fully utilized yet. International expansion will allow for arbitrage of differences in input and output markets, especially in differences between factor costs8 such as labor, capital, energy, land and buildings, lowering the unit costs even further. The sales volume’s inherent increase of the firm’s size strengthens its bargaining position with suppliers, which might allow for further reduction of prices when buying the above named production factors as well as resources. In sum, the company experiencing economies of scale will be able to increase its profitability, probably its cumulative output as well, and thereby achieve a higher return on capital invested. This effect will be even stronger, when the marketed product or service allows for cross-border standardization.

When considering the fact that some locations are more suitable for performing a specific task than others, termed as “national comparative advantage” by Michael Porter9, the realization of location economies is another exploiting benefit. They are defined as “the economic benefits that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting)”10. Beyond further potential for lowering production costs, location economies enable a company to differentiate its product portfolio against its competitors due to increased quality.

Another exploitation benefit is given with the reduction in revenue fluctuations by regional diversification. When addressing several countries, the marketed product is not solely depending on the demand from one economy anymore. The risk of external effects leading to a shrinking sales volume can be diversified between several locations then.

The exploration benefits instead take the perspective of organizational learning and knowledge development. From this point of view, the “main source of benefits from internationalization is (…) in the proactive induction and exhaustion of intra-firm comparative advantages”11. Beyond the synergies from optimized factor costs for one product addressed above, the leveraging of valuable skills developed in foreign subsidiaries and differing product markets are beneficial as well. Especially the chances for innovation and process optimization are given keeping in mind the joint scope but increased cultural diversity. This allows for higher learning curve effects than a single- location supplier might expect given the same sales volume due to the increased competitiveness between domestic and foreign production facilities and economies of scope. The term internalization is closely related to this circumstance and describes another source for exploration benefits. It refers to “bringing new foreign operations within the boundaries of a firm rather than using arm’s-length market transactions”12, by which the sharing of distinctive capabilities and core competencies across countries is enabled.

In sum, the exploration benefits mainly describe why foreign subsidiaries increase a firm’s knowledge and thereby its productivity.

The enormous benefits from international expansion are however accompanied by severe constraints as well. According to the work of Stinchcombe13 and Zaheer14, liabilities of newness and liabilities of foreignness will be differentiated. In addition, costs of complexity will build an important argument later on.

Liabilities of newness describe the fact that at the point in time an organization is created, its risk of termination is at its maximum, but decreases over time15. Stinchcombe names four basic reasons for this phenomenon.

At first new organizations require the formation of new roles. Due to the fact that the organization is just constructed, the employees have to learn the tasks and responsibilities of these roles and are not able to fulfill them completely from the beginning. The second reason, building on the first one, is the fact that until these roles have not been completely defined, information flows do not happen within a controlled environment, but in bilateral communication only.

The latter requires - third reason - trust between the different employees. This is in a new organization however not present from the very beginning but has to be developed over time. So as well does the customers’ trust. Therefore the fourth reason for early enterprise termination is according to Stinchcombe the missing customer base. Another liability of newness not named in the initial article by Stinchcombe is the cost of setting-up a new corporation, i.e. the purchase and installing of facilities, the staffing, the establishment of internal management systems and an external business network beyond the customer base16. When these costs become higher than initially expected, early termination might appear as well.

In sum, the existence of liabilities of newness will at least decrease a newly established corporation’s competitiveness compared to a local, reputable competitor, and in extreme cases lead to the early termination of such.

Liabilities of foreignness instead are not related to the hurdles of a new corporation, but defined as “all additional costs a firm operating in a market overseas incurs that a local firm would not incur”17. There are mainly four sources for such liabilities. The first are direct costs closely related to the distance to the home base such as expenses for travel, transportation, and coordination across distance and time zones. These costs for transmitting goods and information might as well be increased due to different government regulations and trade laws18.

The second source, costs based on the unfamiliarity with the specific foreign, local environment, are expressed in costs related to economical uncertainties19, such as the Euro-zone consequences resulting from the destabilization of their currency, political uncertainties, for example unexpected foreign governmental changes influencing the business environment of the firm20 or financial risks manifested in exchange-rate fluctuations or inflation21. Lu and Beamish22 summarize these factors in an increased probability of making mistakes in a foreign environment.

At third there might be additional home base costs resulting from the expected incapability in the foreign country’s operations. This might be due to excessive control- behavior of the domestic management or other forms of interactions increasing governance and transaction costs based on geographical or cultural dispersion of various principals and agents of the multinational firm23. Gomes and Ramaswamy summarize the third reason for liabilities of foreignness in their statement that “cultural diversity brings problems of communication, co-ordination, control, and motivation”24. The fourth reason lies in additional home base costs arising from customers’ restrictions against business operated from the foreign country. Customers might for example ask for guarantees of product assembly in the firm’s domestic location, which might, depending on the distribution of production facilities according to minimized factor costs, not even be possible.

In sum, the liabilities of foreignness do not decrease the subsidiaries’ profitability, but induce hurdles which influence the parent company negatively. These hurdles however mainly stem from pessimistic managerial behavior, which might be overcome by certain counter-measures. In any case, the main proportion of liabilities of foreignness is expected to decrease over time, too.

Costs of complexity are referring to costs of intra-organizational transaction and coordination beyond the liability of foreignness and the bilateral communication between parent company and subsidiary addressed above. These constraints are in contrast to liabilities of newness and foreignness expected to grow over time.

With a growing degree of geographic diversification, transaction and coordination becomes increasingly intertwined between the parent and its numerous subsidiaries, but between the subsidiaries as well, for example when allocating production factors. Companies are very sensitive towards such decisions, which imply important stipulations and cannot be easily hedged25. Therefore new administrative systems for managing culturally distinct markets as well as diverse human resources are required26. When the company’s markets are in addition highly dissimilar, environmental uncertainty will increase in parallel without allowing for any learning curve effects27. Institutional and cultural factors then represent strong barriers for transferring competitive advantage across country boarders28.

In sum, costs of complexity describe the challenges resulting from heavily expanding internationally and the “increasingly difficult prospect of managing a multicultural, multi- 8 2. Firm-level effects of international expansion location workforce, serving distinctly different customer markets, and navigating through the maze of formidable constraints imposed by the sheer number of locations where operations are established”29. Especially the conflicting demands for achieving cost reduction by clever allocation of production factors on the one and for local responsiveness by serving the local conditions on the other hand produce the need for very high managerial information-processing, which might easily exhaust managerial capacities30.

As shown above, international expansion enables a company for realizing high additional benefits, but implies severe constraints as well. Before engaging into a new international venture, companies therefore have to carefully analyze all possible consequences in advance.

2.2 Views on the relationship between international expansion and firm performance

The aggregation of beneficial and costly influences of internationalization will lead to a deduction of the relationship between international expansion and firm performance. However different opposing theoretical approaches have been developed over time. While early researchers were examining linear correlations between multinationality and performance31, more recent approaches revealed curvilinear connections. The latter however can again be distinguished concerning the forms of their shapes resulting from graphing performance against multinationality, ranging from J-shapes through U- and inverted-U-shapes to S-shapes. This contrariness becomes rather an evolutionary development, when being closely analyzed. This will be shown in this chapter.

While linear shapes were discussed in literature, the above analysis of benefits and constraints of internationality was able to highlight its positive as well as the negative impacts on performance. Only when considering the costs and benefits appearing independently from the level of multinationality or international diversification, for example exploitation benefits, the relationship might be linear. The above discussion however showed that some consequences, especially exploration benefits or costs of complexity, develop over time and together with the number of international engagements. Since these developments might change the relation between both sides of the equation and in some cases the preceding sign of its result as well, linear relationships are rather unrealistic and consequently not of further interest in this paper. The relationship is more complex.

As mentioned above, the more recent studies on the relationship between international expansion and firm performance indicate curvilinear connections. Gomes and Ramaswamy32 for example postulate a J-shaped performance, when being graphed against multinationality.

illustration not visible in this excerpt

Figure 1: The Diminishing Returns Model of Multinationality Source: Gomes/ Ramaswamy (1999), p. 175.

Their main argument for this relationship is that “continued foreign expansion would be accompanied by decelerating profit growth and negative marginal returns beyond some optimal level of multinational activity”33. When expanding beyond this optimum, the expenses termed as “costs of complexity” in the above chapter, mainly consisting of “costs associated with control and coordination of far-flung subsidiaries, and the administrative obstacles encountered in managing culturally dissimilar and distinct markets”34, will exceed additional gains from internationalization.

In the early phase of increasing multinationality, which is according to Gomes and Ramaswamy characterized by choosing highly familiar markets as targets35, existing products and services can easily and efficiently be rolled out to a larger market without bearing much higher costs. Administrative and organizational structures will still fit the additional purpose, while costs for exporting the product or service will remain low. The company’s net effect will therefore most probably be positive in the end.

Driven by the early success of marginal international expansion, most companies will then enter higher distant markets relatively soon. Beyond the decreasing potential out of the difference between additional foreign markets and increasing transaction costs, “complex intraorganizational flows of products, capital, personnel, knowledge, and information”36, but as well difficulties in communication, co-ordination, control and motivation37 due to higher cultural distance are diminishing the benefits of the early stage. The global leveraging of organizational knowledge through exploration benefits will be very difficult to manage. Exploitation benefits will still arise, however being diminished by higher liabilities of foreignness compared to nearshore38 locations. Summing up the effects of increasing internationalization in the late stage, Gomes and Ramaswamy expect that “the marginal performance becomes negative beyond the point of optimality, since incremental costs exceed incremental benefits”39.

The summary of their arguments is given in their statement that “while marginal returns may exceed marginal costs for moderate levels of foreign presence, beyond an optimal point the marginal returns enter negative territory. Thus, a firm starting out with only a handful of subsidiaries may be able to manage information and resource flows across its network relatively easily, while reaping the benefits of multinationality. It can therefore be expected to enjoy returns that exceed its costs at the margin. However, with continued expansion, the complexities of managing information and resource exchanges among widespread units may well result in costs escalating at a faster rate than returns”40.

The authors as well empirically tested this hypothesis using longitudinal data from 95 MNEs out of the United States. Firms were selected to at least generate ten percent of their sales overseas without being widely diversified, i.e. all generating more than 70 percent of sales in one single business.

Internationality was measured with a composite index encompassing three dimensions, international sales calculated as foreign sales to total sales (FSTS), international assets calculated as foreign assets to total assets, and the number of foreign countries in which the firm had subsidiaries. The calculation of the index is however not described in more detail by the authors. Performance was measured with two indicators. The first was return on assets (ROA), giving a financial suggestion of internationalization effects. The second indicator was operating costs to sales (OPSAL), highlighting the consequences for operational efficiency.

As result, the authors’ curvilinearity hypothesis was supported. Moderate levels of internationalization were “beneficial in terms of reducing operating costs per unit of sales, and enhancing return on assets”41, while high levels resulted in the opposite effect. The infection points of this turn were determined to be 1.2 for ROA and 0.89 for OPSAL42 in multinationality-index points, given their study’s data sample.

Hitt, Hoskisson and Kim43 argue in a similar chain of cause and effect, postulating an inverted U-shape of firm performance when being graphed against internationality. They explain that effects from international diversification are in the early stage positive, mainly due to economies of scale, scope and experience44. Firms are able to leverage their internal resources and gain additional competitive advantage over their foreign competitors.

However with increasing international diversification, the company becomes “highly complex and difficult to manage. At some point, the complexity overwhelms the positive benefits of international diversification, and performance begins to suffer”45. The authors investigate these costs of complexity in more detail, highlighting the role of the company’s management as well as the effects of product diversification on its extent. Costs of complexity are highly dependent on a firm’s management capabilities, because they are mainly due to the difficulties arising from coordinating a multi-location workforce and serving distinct customer markets. The governance scope implied by these decisions might easily exceed management’s abilities and skills46. Strategic controls “also require substantial coordination and face-to-face interaction between corporate and business-unit managers”47. The demand for information necessary for adequately supervising the diverse businesses cannot be handled by the corporate manager anymore. In this situation, “corporate executives shift from an emphasis on strategic controls to an emphasis on financial controls”48. Strategic control requires an effective understanding of each country’s business and market but as well an intense communication and coordination between domestic and foreign managers. To avoid the necessary transaction of knowledge and information, financial control systems, often based on standardized key performance indicators and internationally comparable parameters, are then introduced. It results in an increase of manageability of diverse subsidiaries for the corporate manager, but as well increases the risk and personal liability of business-unit managers. Their responsibility shifts from supplying sufficient information for the corporate manager to take decisions towards being responsible for delivering satisfying results based on their own decisions. The behavioral result is a reduction in long-term planning and investment, such as R&D, because “the incentive compensation system for business-unit managers (implied by the shift of responsibility) reduces the attractiveness of such investments”49. New product development, stated as being essential for being able to deliver high quality at low cost50 nowadays, is thereby hindered.

Product diversification is described by the authors as having a positively moderating effect on costs of complexity due to increased international expansion51. From the resource-based perspective, they argue “experience with product diversification can build managerial capabilities that allow more effective management of international diversification”52. The additional experience in interacting in different market environments, handling a diverse workforce and coordination several distinctive business units gained through managing the intra-country but inter-business unit complexities from product diversification, can be applied in overcoming the hurdles of international diversification as well. Thereby the company’s knowledge can be leveraged in terms of an “efficient structure, better governance, and enhanced managerial capabilities”53.

For testing their theoretical hypotheses, Hitt, Hoskisson and Kim analyzed a sample of 295 large54 firms between 1988 and 1990. Performance was measured in ROA. For observing international diversification, an entropy measure was introduced, differentiating the sales attributed to “four relatively homogeneous global regions: Africa, Asia and Pacific, Europe, and the Americas”55. In addition, the authors took R&D intensity and product diversification into account. The first has been used as a proxy for innovation and was measured in the ration of R&D expenditure to the firm’s total number of employees. For the latter, another entropy measure, taking into account the sales attributed to the diverse segments a company operates in, has been introduced.

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Figure 2: Interaction Effect of Product and International Diversification on ROA Source: Hitt/ Hoskisson/ Kim (1997), p. 787.

As a result, the inverted-U shape relationship between firm performance and multinationality has been supported56 for the overall sample used. When subdividing the sample into groups of non-diversified or single-business firms, moderately productdiversified firms, and highly product-diversified firms the moderating effect of producton international diversification became observable.

For single-business or non-product-diversified firms the relationship between internationalization and performance was highly negative. This suggests that the potential benefits of internationalization were not experienced. It empirically supports the authors’ view that managers of single-business firms “are unlikely to have developed adequate skills in managing information-processing demands”57 due to the missing need for coordinating diverse groups across differing markets. Learning how to solve complex intra-organizational conflicts beyond one business unit being involved did not occur to the managers and not to the organization. Non-product-diversified firms “do not have organizational structures appropriate for managing these information-processing demands”58. The authors expect such companies to rather develop structures leading to increasing information processing and transaction costs, for example due to the appearance of novel internal conflict situations59. Continuing international exposure however seems to introduce positive returns for them as well. This happens approximately at 1.0796 international diversification index-points for this sample. It might be due to organizational learning, for example in the necessary management skills or efficient organizational structures60.

For moderately product-diversified firms, the relationship between performance and multinationality has initially been positive, but became negative with increased international diversification. In the early stage of internationalization the authors expect such firms to diversify in related products and nearshore locations, which enable them to experience exploitation benefits and synergies while bearing proportionally lower additional costs. Usually the organizational governance already applied while diversifying in products facilitates the coordination across related international businesses “with significant structural integration among units and substantial centralized direction and oversight by the corporate office”61. Similar to Gomes and Ramaswamy, Hitt, Hoskisson and Kim however observed an infection point, at which the performance levels off and becomes negative. It is at approximately 0.5157 international diversification index-points for this sample. Furthermore, “continuing international diversification efforts after this point produces the most negative performance exhibited among the types of firms studied”62. The costs of complexity addressed above significantly increase the information-processing demand, when crossing this point. In addition, liabilities of foreignness arise to a higher extent when deciding for offshore market presence. Centralized decision making will due to the depleted managerial capabilities not be efficient anymore, but decentralized is not proven in the company yet. Either the firm then decides to accept the decrease in performance and continues operating less profitable, or decides for bearing additional costs for transferring into a decentralized organization and revisited organizational learning.

The relationship between productivity and multinationality for highly product-diversified firms is positive and without any turning point, but only slightly decreasing with high levels of internationalization. Their managers are expected to “have the experience and thus the skills to manage the complexity as well as the structures that partially attenuate the information-processing demands created by international diversification”63. Organizational learning took place already in the past and can be leveraged for the international expansion as well.

In summary, the authors propose firms to enter international markets cautiously and well prepared64. Especially the learning of required management skills, adequate organizational structures and a proper form of decision making is heavily influencing the international venture’s outcome. In addition, the occurrence of shifts in control systems from strategic to financial measures and the resulting management’s risk-aversion and short-term orientation65 including its firm-level consequences should be considered properly.

Ruigrok and Wagner66 emphasize the key role of organizational learning in transferring international expansion into positive effects on firms’ performance as well. Even though they postulate a U-shaped relationship between multinationality and performance, and thereby heavily differ from the theories highlighted above, the factor introducing the turning point at the global minimum of the shape is the firm’s ability to leverage its global capabilities. They agree that “firms capable of generating, combining and transferring intangible assets or tacit knowledge within operating units that span a variety of cultural environments obtain the most valuable internationalization benefits”67. In line with the reasoning applied by Hitt, Hoskisson and Kim, the moderating role of the management is however addressed as well. “Internationalization per se is not a sufficient condition for superior performance”68, but the benefits have to be harvested actively.

For testing their hypothesis empirically, Ruigrok and Wagner studied 84 out of the top 500 German companies in a five-year period between 1993 and 1997. The firms observed stem from four industrial manufacturing sectors, namely automotive, chemicals, metals and machinery. Internationalization was measured in FSTS again. Corporate performance has been separated into a financial and an operational component. For the first part ROA was applied, operating costs to total sales (OPSAL) for the latter. As a result, the authors were able to prove the existence of a curvilinear relationship between companies’ degree of internationalization and performance, which has been taken as evidence for the proposed standard-U form69. For the sample used, the global minimum of ROA has been identified at 61% FSTS. OPSAL were at their maximum at 54% FSTS, indicating the highest operating inefficiency at this proportion of foreign sales.

While analyzing these results more precisely, the authors give a more detailed theoretical rationale for the turning point. For ROA the authors expect firms to experience an internationalization threshold according to the empirically proven U-shape. However through organizational learning “once effectively adapted, MNCs are in good position to rapidly reap the benefits flowing from high degrees of internationalization”70. This effect is even strengthened by the additional gains from increased operating efficiency, manifested in a lagged learning curve, which starts growing at 54% FSTS71 without any preceding decline due to increased internationalization.

Summing up their view of multinationality’s influence on performance, the authors “suggest that MNCs pass through an organizational learning process characterized by internal reconfiguration that allows for superior performance development at high DOIs (degrees of internationalization). The relatively long period of performance deterioration that accompanies this adjustment process may explain why many firms eventually resign and de-internationalize again before reaching the turn-point”72.

In this chapter, the complex rationale behind the influence of multinationality on firm performance has been enlightened. It is far more multifaceted than linear, taking into account diverse factors such as the degree of internationalization, management capabilities, product diversification and organizational learning. For every single firm there will be a distinct composition of these factors, resulting in unique reactions in performance based on multinationality. However, a basic estimation concerning the interplay of factors can be made at this point. Specific conditions and circumstances seem to occur and influence the relationship between international expansion and firm performance at particular stages of its lifecycle.

2.3 Common findings: The S-curve hypothesis

Given the empirical significance of Ruigrok and Wagner’s hypothesis, but as well the differing theories of further scholars addressed above, they have tried to engage into additional explanation of such contrasts by evincing country-specific idiosyncrasies73. While US firms prefer to locate initial foreign activities into other English-speaking and high familiarity countries such as Canada, the United Kingdom or Australia, “the average German firm expanded early into other European, North American, and Asian countries, nations characterized by higher psychic distance”74.

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Figure 3: The Role of Type of Expansion (Culturally Related/ Unrelated) Source: Ruigrok/ Wagner (2003), p. 79.

The authors find that as long as US companies follow their habit of related expansion into highly familiar markets, they are likely to experience an increase in performance. When then entering offshore locations and thereby unrelated expansion, they will from that point pass through the same U-curve relationship between multinationality and performance German companies usually do.

A similar rationale is as well presented by Lu and Beamish75. They even extent it into a three-phase model of international expansion’s influence on firm performance and give theoretical arguments as well as empirical longitudinal evidence for a horizontal S-curve relationship, assembling the separate arguments out of the seemingly contradictory theories explained above into one consistent chain of cause and effect.

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Figure 4: Multinationality and Performance: A Three-Phase Model Source: Lu/ Beamish (2004), p. 600.

The smooth solid line described the cumulative benefits from internationalization, taking into account both exploitation and exploration benefits. As already highlighted they will increase with additional international expansion. The smooth dotted line represents the total costs of internationalization, being the sum of the further three dotted lines with markers. Liabilities of foreignness and liabilities of newness are very observably in early stages of internationalization, but tend to level off at the point when organizations have learned how to deal with such. Costs of complexity, termed coordination costs in the figure above, however continue increasing with higher degrees of internationalization. From the sum of all the costs and benefits, a net gain from internationalization, differing between the three stages of the process, will arise.

In the initial phase, firms will be able to leverage exploitation benefits for increasing their revenues. They will however as well “encounter liabilities of newness and foreignness in which it must pay some ‘tuition’ in the form of reduced profits resulting from such disadvantages”76. Lu and Beamish expect this type of firms engaging into international expansion the first time to be young, small and not product-diversified77. Therefore, the negative net gain postulated in their study is consistent with findings of Hitt, Hoskisson and Kim as well as Ruigrok and Wagner described above.

When continuing international expansion in the second phase, the firms will experience organizational and managerial learning about how to efficiently coordinate, monitor and control the multi-location workforce and serving distinct customer markets. Exploration effects increase total benefits even further, since “growing geographic diversification enables asset advantages to be exploited across a greater spread of markets, which occurs alongside the development of new capabilities in international markets”78. However keeping the organization efficient requires a lot of attention and cautiousness, which will start costs of complexity rising. In the course of additional international expansion, costs for governance and coordination will increase up to the infection point at which costs can surpass the benefits of geographic diversification, and overall firm performance declines again79. As highlighted by Hitt, Hoskisson and Kim, the hierarchical organization will at this point face its limits, but the necessary shift of control from centralized to decentralized management would decrease synergies and lead to additional reductions in benefits due to the latter managers’ lack of learning effects. Net benefits in this second phase will therefore experience their highest growth in the beginning, level-off due to increasing costs of complexity and finally introduce the point “at which the governance costs exceed any internationalization benefits”80.

In this third phase the theoretical concept of Lu and Beamish ends, indicating that any marginal international expansion would exponentially increase benefits and even more costs of complexity, leading to a further decrease in net gains from internationalization. The authors tested their hypothesis in a large sample of 1,489 Japanese firms, reaching from 1986 until 1997. Since the number of foreign investments made per company in this sample varied between one and 601 and the number of host countries lay between one and 61, the analysis covered firms from all stages of the three-phase model81. Performance was again split up into the accounting-based financial performance measure ROA and the market-based financial performance measure Tobin’s Q, defined as the market value of assets divided by their replacement value. It thereby captures the firm’s ability of leveraging its assets. Internationality was measured using the integrated average of two ratios. The first was the count of the firm’s overseas subsidiaries, the second the count of the countries these subsidiaries were in. Internationalization thereby “took values ranging from 0 to 1, with 1 representing the highest level of internationalization in our sample”82.

As result, their hypothesis was strongly supported. Firm performance was negatively related to the linear function of internationalization, positively related to its square, and again negatively to its cubic83. Phase one’s local minimum of the net gains from internationalization were in this sample at a DOI of 0.2, while the local and global maximum in phase two was given at a DOI of 0.884.

Summarizing the above, Lu and Beamish were able to conclude the previous theories regarding multinationality’s effect on firm performance based on common findings within one approach. When considering “that the inverted U-shape typifies research conducted on samples of well-internationalized firms (…) and that the upright U emerged in a sample of newly internationalizing firms (…), our findings present a reconciliation of this prior research”85.

Furthermore, the authors suggest potential managers how to treat internationalization decisions. Taking a long-term perspective when evaluating the success of former international ventures will prevent from miss-valuing the lack of early returns on such. Instead, “during early stages of international expansion, managers need to be cognizant of the potential downside of excessive international expansion and to be proactive in the design and implementation of international strategies by optimizing the configuration of subsidiary networks to keep the scope of internationalization activities at an optimal level”86. Managers therefore should focus on developing a way of thinking, capabilities, and organizational structures for handling the expected complexities addressed above, but as well the timing and the pace of internationalization, in a way such that the benefits from multinationality can be leveraged effectively.


1 Hill/ Jones (2010), p. 245.

2 Comp. Lu/ Beamish (2004), p. 599.

3 Comp. Rugman (1979).

4 Hill/ Jones (2010), p. 251.

5 Comp. Gomes/ Ramaswamy (1999), p. 175.

6 Gomes/ Ramaswamy (1999), p. 176.

7 Comp. Hill/ Jones (2010), p. 251f.

8 Comp. Gomes/ Ramaswamy (1999), p. 174.

9 Comp. Porter (1990), p. 77.

10 Hill/ Jones (2010), p. 254.

11 Ruigrok/ Wagner (2003), p. 67.

12 Hitt/ Hoskisson/ Kim (1997), p. 767.

13 Comp. Stinchcombe (1965).

14 Comp. Zaheer (1995).

15 Comp. Stinchcombe (1965), p. 148f.

16 Comp. Lu/ Beamish (2004), p. 599.

17 Zaheer (1995), p. 342.

18 Comp. Hitt/ Hoskisson/ Kim (1997), p. 772.

19 Comp. Hill/ Jones (2010), p. 255.

20 Comp. Ruigrok/ Wagner (2003), p. 67.

21 Ibidem, p. 67.

22 Comp. Lu/ Beamish (2004), p. 599.

23 Comp. Ruigrok/ Wagner (2003), p. 67.

24 Gomes/ Ramaswamy (1999), p. 177.

25 Comp. Hitt/ Hoskisson/ Kim (1997), p. 773.

26 Comp. Gomes/ Ramaswamy (1999), p. 174.

27 Comp. Lu/ Beamish (2004), p. 599f.

28 Comp. Hitt/ Hoskisson/ Kim (1997), p. 773.

29 Gomes/ Ramaswamy (1999), p. 177.

30 Comp. Hitt/ Hoskisson/ Kim (1997), p. 772.

31 Comp. Gomes/ Ramaswamy (1999), p. 175.

32 Comp. Gomes/ Ramaswamy (1999).

33 Ibidem, p. 174.

34 Ibidem, p. 174.

35 Ibidem, p. 175.

36 Gomes/ Ramaswamy (1999), p. 177.

37 Ibidem, p. 177.

38 Nearshoring is defined as the relocation of business processes and operations into a foreign country, which is geographically close to the domestic country of a firm. It is deviated from the term offshoring, which describes the relocation into more distant, often overseas countries.

39 Gomes/ Ramaswamy (1999), p. 177.

40 Ibidem, p. 178.

41 Gomes/ Ramaswamy (1999), p. 182.

42 Ibidem, p. 184.

43 Comp. Hitt/ Hoskisson/ Kim (1997).

44 Ibidem, p. 788.

45 Ibidem, p. 789.

46 Ibidem, p. 770.

47 Ibidem, p. 777.

48 Ibidem, p. 770.

49 Hitt/ Hoskisson/ Kim (1997), p. 777.

50 Ibidem, p. 768.

51 Ibidem, p. 770.

52 Ibidem, p. 770.

53 Ibidem, p. 776.

54 Average sales exceeding USD 100 million per year.

55 Hitt/ Hoskisson/ Kim (1997), p. 780.

56 Comp. Hitt/ Hoskisson/ Kim (1997), p. 782ff.

57 Ibidem, p. 789.

58 Hitt/ Hoskisson/ Kim (1997), p. 789.

59 Comp. Ibidem, p. 789.

60 Comp. Ibidem, p. 789.

61 Ibidem, p. 790.

62 Ibidem, p. 790.

63 Hitt/ Hoskisson/ Kim (1997), p. 790.

64 Comp. Ibidem, p. 791.

65 Comp. Ibidem, p. 777.

66 Comp. Ruigrok/ Wagner (2003).

67 Ibidem, p. 70.

68 Ibidem, p. 68.

69 Comp. Ruigrok/ Wagner (2003), p. 74.

70 Ibidem, p. 77.

71 Comp. Ibidem, p. 77.

72 Ibidem, p. 77.

73 Comp. Ruigrok/ Wagner (2003), p. 78.

74 Ibidem, p. 78.

75 Comp. Lu/ Beamish (2004).

76 Lu/ Beamish (2004), p. 601.

77 Comp. Ibidem, p. 601.

78 Lu/ Beamish (2004), p. 601.

79 Comp. Ibidem, p 601.

80 Ibidem, p. 600.

81 Comp. Ibidem, p. 602.

82 Lu/ Beamish (2004), p. 603.

83 Comp. Ibidem, p. 605.

84 Comp. Ibidem, p. 605.

85 Ibidem, p. 606.

86 Ibidem, p. 607.

Excerpt out of 94 pages


The use of real option reasoning in international market entry decisions
University of Vienna
Internationale Betriebswirtschaft
Catalog Number
ISBN (eBook)
ISBN (Book)
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1648 KB
Real Option Reasoning, Market Entry, International Market Entry, Real Option Theory, Acquisitions, Greenfield Investment, Joint Ventures, Franchising, Exporting / Licensing
Quote paper
Jan-Malte Prädel (Author), 2012, The use of real option reasoning in international market entry decisions, Munich, GRIN Verlag,


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