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
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