Foreign Direct Investment

13
Chapter
Foreign Direct Investment
13. 1
Slides by Yee-Tien (Ted) Fu
Going International
Entry Strategy
Risk-Return
Tradeoff
Commitment
PeriodResource
Exit Strategy
Export-Import
Business
Low-low
Variable-min.
Easy
Licensing
Medium-stable
Longtechnology
Terms of
contract
Franchising
Medium-stable
Long-service &
equipment
Terms of
contract
International
Joint Ventures
Sizable-high
Long-equity
arrangement
Terms of
contract
Strategic
Alliances
Low-high
Variable-non
equity
Cooperative
venture
Foreign Direct
Investment
High-high
Long-equity
arrangement
Careful
planning before
entry
13. 2
Foreign Direct Investment
FDI is an extremely important component of BOP as
it helps fund Current Account deficits and increases
inflows of foreign savings that lead to faster
economic growth.
MNCs are increasingly setting their FDI sights on
emerging economies, e.g., BRICS for future growth
and profit potential. Yet, weak institutions aborad
create challenges such as corruption, political risk,
regulatory obstacles, social divisions, and civil strife.
13. 3
Chapter Objectives

To describe common motives for initiating direct
foreign investment (DFI); and

To illustrate the benefits of international
diversification.
13. 4
Motives for FDI
• MNCs commonly consider FDI because it can
improve their profitability/growth and enhance
shareholder wealth.
• MNCs try to achieve their FDI objective by
boosting revenues, reducing costs, or doing both.
13. 5
Revenue-Related Motives for FDI
13. 6
Cost-Related Motives for FDI
13. 7
Cost-Related Motives for DFI
13. 8
World’s Ten Largest Economies:
PPP Basis
13. 9
Comparing the Benefits of FDI
Across Countries
• The optimal method for a firm to penetrate a
foreign market is partially dependent on the
characteristics of the market.
• For example, if the consumers are used to
buying products from local firms, then
licensing arrangements or joint ventures may
be more appropriate.
13. 10
Comparing the Benefits of FDI
Across Countries
• Before investing in a foreign country, the potential
benefits must be weighed against the costs and
risks associated with that specific country.
• In particular, the MNC will want to review the
foreign country’s economic growth and other
macroeconomic indicators, as well as the political
structure and policy institutions.
• Local institutions are often informal, weakly
formalized, in transition, or sometimes
nonexistent.
13. 11
Comparing the Benefits of FDI
Over Time
• As conditions change over time, some
countries may become more attractive targets
for FDI, while other countries become less
attractive.
• Asia (China, India, and Indonesia in particular)
now receive a larger proportion of DFI than in
the past.
13. 12
Benefits of International
Diversification
• The key to international diversification is to
select foreign projects whose performance
levels are not highly correlated over time.
• This way, the various international projects are
less likely to experience poor performance
simultaneously.
13. 13
Diversification Benefits for
Merrimack Co.
Merrimack Co., a U.S. firm, plans to invest in
a new project in either the U.S. or the U.K.
13. 14
Diversification Benefits for
Merrimack Co.
• In terms of return, neither new project has an
advantage.
• With regard to risk, the new project is expected to
exhibit slightly less variability in returns if it is
located in the U.S.
• However, estimating the risk of the individual
project without considering the overall firm would
be a mistake.
13. 15
Diversification Benefits for
Merrimack Co.
• Suppose that the new project will constitute 30%
of Merrimack’s total funds invested in itself, and
that the standard deviation of return on its existing
business is .10.
• If the new project is located in the U.S., the
portfolio variance for the overall firm
 w A2σ 2A  w B2σ B2  2w Aw Bσ Aσ BCORRAB
 .70 2.10 2  .30 2.09 2  2.70 .30 .10 .09 .80 
 .008653
13. 16
Diversification Benefits for
Merrimack Co.
• If the new project is located in the U.K., the
portfolio variance for the overall firm
 w A2σ 2A  w B2σ B2  2w Aw Bσ Aσ BCORRAB
 .70 2.10 2  .30 2.112  2.70 .30 .10 .11.02
 .0060814
• Thus, as a whole, Merrimack will generate
more stable returns if the new project is
located in the U.K.
13. 17
Geographic Diversification of
International Projects
• Like any investor, an MNC with projects positioned
around the world is concerned with the risk and
return characteristics of the projects.
• The portfolio of all projects reflects the MNC in
aggregate.
13. 18
Risk-Return Analysis of
International Projects
• When the projects are combined appropriately, the project
portfolio may be able to achieve a risk-return tradeoff
exhibited by any of the points on the frontier of efficient
project portfolios.
13. 19
Geographic Diversification of
International Projects
• Project portfolios along the efficient frontier exhibit
minimum risk for a given expected return.
• Of these efficient project portfolios, an MNC may
choose one that corresponds to its willingness to
accept risk.
• The actual location of the frontier of efficient
project portfolios depends on the business in
which the firm is involved.
13. 20
Product Diversification of
International Projects
• Some MNCs have frontiers of possible project portfolios
that are more desirable than the frontiers of other MNCs.
13. 21
Diversification Analysis of
International Projects
• Our discussion suggests that MNCs can
achieve more desirable risk-return
characteristics from their project portfolios if
they sufficiently diversify among products and
geographic markets.
13. 22
Decisions Subsequent to FDI
• Even before FDI decision is made, an exit strategy
needs to be designed, analyzed, and put in place
• Some periodic decisions are necessary:
• Should further expansion/contraction take place?
• Should earnings be remitted to the parent, or used
by the subsidiary?
• These decisions should be analyzed on a caseby-case basis.
13. 23
Host Government View of FDI
• Each government must weigh the advantages
(jobs, skills, technology, tax revenues, etc.) and
disadvantages (corruption, environmental
degradation, labor exploitation, etc.) of FDI in its
country.
• The government may provide incentives to
encourage desirable forms of FDI, and impose
preventive barriers or conditions on other forms of
FDI.
13. 24
Incentives to Encourage FDI
• The ideal FDI solves problems such as
unemployment and lack of technology without
taking business away from the local firms.
• Common incentives offered by host governments
include tax breaks, discounted rent for land and
buildings, low-interest loans, subsidized utilities,
and reduced legal/environmental restrictions.
13. 25
Barriers to FDI
• Governments are less anxious to encourage FDI
that increases domestic competition and adversely
affects local firms, consumers or the economy.
• FDI barriers include regulations governing
mergers and acquisitions, restrictions on foreign
ownership of local firms, red tape (procedural and
documentation requirements), the political
influence of local firms, corruption and political
instability.
13. 26
Government-Imposed
Conditions to Engage in FDI
• Some governments or agencies like the European
Commission allow international acquisitions but
impose strict anti-trust provisions on the MNCs
that desire to acquire a local firm.
• Such conditions include environmental
constraints, restrictions on market share, local
sales, and employment requirements.
13. 27