Nov 2016 Q2 b.
KK Chemicals Ltd, an Accra-based manufacturer of paints, sells its products only in Ghana. Currently, the company wants to expand into other African countries. The directors are considering two options: set up its own subsidiary company to manufacture and sell the products or license a company based in the host country to manufacture and sell the products.
Required:
i) Advise the directors on TWO potential advantages and TWO disadvantages to KK Chemicals of setting up its own subsidiary company to handle production and sale in the host country as against licensing a company in the host country to do that. (4 marks)
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Advantages:
- If KK Chemicals set up its own subsidiary to handle the production, it will be able to protect its production secrets and technology from being replicated. With licensing, KK Chemicals will have to disclose its production process and technology to the licensee and risk replication.
- KK Chemicals will maintain total control over the quality of the products. Controlling the quality of the product under licensing is a bit difficult.
- With a subsidiary, KK Chemicals will earn all the revenue from the sale of the product and not just a small percentage of it as royalty. That is setting up in the host country would be a more effective way of growing the company’s earnings.
Disadvantages
- Setting up a subsidiary in the host country requires a substantial amount of money. This may cause the company to restrict dividend payments to make more earnings available to finance the operation or borrow more. Lower dividends may not meet shareholders’ expectation while high borrowing will increase financial risk.
- Setting up a subsidiary in the host country exposes the company to higher political risk than licensing would do. Political risks such as expropriation, business interruption in times of political unrest or ethnic tensions, blocked funds, changes in shareholding rules could be avoided with licensing.
ii) Suppose KK Chemicals elects to set up a subsidiary in the host country. Suggest to the directors TWO ways of dealing with the risk of blocked funds. (2 marks).
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Blocked funds refers to the situation where the government of the host country uses exchange controls to block the flow of foreign exchange into and out of the country. When this happens, KK Chemicals would not be able to remit cash returns back home. KK Chemicals can deal with blocked funds by doing any of the following:
- Sell goods or services to the subsidiary and obtain payment.
- License the subsidiary to use its production processes protected by patent for royalties.
- Offer management services to the subsidiary for a fee.
- Give more loan (rather than equity) finance to the subsidiary for interest payment.