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Chapter Objectives

1. To evaluate the arguments for and against foreign direct investment.


2. To list and describe modes of foreign investment.
3. To discuss foreign direct investment in the Third World.
4. To list the factors that affect cross-border mergers and acquisitions.
5. To describe the major differences in mergers and corporate governance beteen
the !nited "tates and #apan.
Chapter Outline
$. %n &vervie of 'oreign (irect $nvestment
%. The !.". (epartment of )ommerce defines foreign direct investment as
investment in either real capital assets or financial assets ith a minimum
of 1* percent equit+ onership in a foreign firm.
i. These investments usuall+ require a large sum of mone+ and are
made in e,pectation of benefits over an e,tended period.
ii. These investments are not readil+ reversible once the+ are made.
-. -enefits of foreign investment.
i. )ompan+ benefits.
1. /0)s invest their capital abroad to utili1e their oligopol+-
created advantages including proprietar+ technolog+2
management 3no-ho2 multinational distribution
Corporate Strategy and Foreign Direct Investment 231
17
Corporate Strategy and
Foreign Direct Investment
netor3s2 access to scarce ra materials2 production
economies of scale2 financial economies of scale2 and
possession of a strong brand or trade name.
2. The use of these advantages allos the /0) to reduce its
cost of capital and to increase its profitabilit+.
ii. 4ost-countr+ benefits.
1. '($ forms one the most important lin3s beteen
developing and industrial countries because it is stable.
2. '($ induces the transfer of technolog+ and s3ills that are
frequentl+ in short suppl+.
3. '($ increases both national emplo+ment and domestic
ages.
4. '($ provides local or3ers ith an opportunit+ to learn
managerial s3ills.
5. '($ contributes to ta, revenues and helps balance the
international balance of pa+ments.
). %rguments again foreign investment.
i. )onflicts beteen compan+ goals and host-government
aspirations.
1. '($ brings about the loss of political and economic
sovereignt+.
2. '($ controls 3e+ industries and e,port mar3ets.
3. '($ e,ploits local natural resources and uns3illed or3ers.
4. '($ undermines indigenous cultures and societies b+
imposing Western values and lifest+les on developing
countries.
(. /odes of 'oreign $nvestment
i. )onstruction of ne plants 5internal groth6 7 the establishment of
ne operations in foreign countries to produce and sell ne
products.
1. )an tailor foreign operations to meet e,act needs.
2. $t ta3es time for /0)s to reap an+ reards from internal
groth because the+ have to build a plant and establish a
customer base.
ii. /ergers and acquisitions 5e,ternal groth6 7 the acquisition or
merger of other firms in foreign countries.
1. 'aster than internal development. $n man+ cases it is
instant access and can often reduce the position of
competititors.
iii. #oint venture 7 a venture oned b+ to or more firms2 in some
cases from several different countries.
1. The basic advantage is that it enables a /0) to generate
incremental revenue or cost saving.
2. The disadvantages are comple, and have to do ith
difficulties forging a consensus and sharing authorit+.
Corporate Strategy and Foreign Direct Investment 232
iv. 8quit+ alliance 7 an alliance here one compan+ ta3es an equit+
position in another compan+.
1. $n some cases2 each part+ ta3es an onership in the other.
2. The purpose is to solidif+ a collaborative contract so that it
is difficult to brea3.
v. 9icensing agreement 7 an agreement here an /0) 5the licensor6
allos a foreign compan+ 5the licensee6 to produce its products in
a foreign countr+ in e,change for ro+alties2 fees2 and other forms
of compensation.
1. The advantages to a licensor are.
a. % relativel+ small amount of investment.
b. %n opportunit+ to penetrate foreign mar3ets.
c. 9oer political and financial ris3s.
d. %n eas+ a+ to circumvent foreign mar3et entr+
restrictions.
2. The advantages to a licensee are.
a. % cheap a+ to obtain ne technolog+.
b. %n eas+ a+ to diversif+ into other product lines.
c. %n opportunit+ to capitali1e on its unique positions.
3. "uccessful licensing requires management and planning.
vi. 'ranchising agreement 7 an agreement here an /0) 5franchiser6
allos a foreign compan+ 5franchisee6 to sell products or services
under a highl+ publici1ed brand name and a ell proven set of
procedures.
1. This accounts for one-third of !.". retail sales.
vii. )ontract manufacturing 7 the /0)s contracts ith a foreign
manufacturer to produce products for them according to their
specifications.
1. The contract manufacturer does not mar3et the products it
produces: instead the+ are mar3eted b+ the /0)s under
their brand name.
$$. 'oreign (irect $nvestment in (eveloping )ountries
%. 8quit+ related finance to developing countries ta3es to forms. portfolio
investment and direct investment.
i. )ombined inflos of both forms totaled about ;152 billion in
2**2.
ii. 0et '($ flos to developing countries fell sharpl+ in 2**2 to ;143
billion from ;1<2 billion in 2**1.
1. This decline as caused b+ declines of '($ in 9atin
%merica and the )aribbean.
2. This donturn as relative to a global '($ flo decline
from ;=24 billion in 2**1 to ;>51 billion in 2**2.
-. % first step to attract '($ is to improve the investment climate.
i. There are man+ obstacles to '($.
Corporate Strategy and Foreign Direct Investment 233
1. "ome of these obstacles are unavoidable2 inadvertent or
unintended. This includes bad roads2 primitive port
facilities2 and a lac3 of local capital or qualified local
technicians.
2. "ome of these obstacles are government sanctioned.
3. "ome of these obstacles are government related but are
unintended2 such as red tape and corruption.
ii. There are broad groups of reasons h+ /0)s ill invest in
developing countries.
1. ?arious incentive programs.
a. This includes tariff e,emptions2 ta, incentives2 and
financial assistance.
2. 8merging mar3et-based capitalism.
a. This includes privati1ation2 liberali1ation of trade2 a
positive attitude toard foreign investment2 a
rela,ation of tight state control2 stoc3 mar3et
development2 and sounder macroeconomic policies.
iii. &ne critical factor of the domestic polic+ environment in attracting
foreign investment is hether the government operates ith
transparenc+2 credibilit+2 and stabilit+.
1. )orporate governance is essential to sustain '($ inflos.
$$$. )ross--order /ergers and %cquisitions
%. )ompanies gro internationall+ primaril+ through to a+s.
i. Through the construction of ne production facilities in a foreign
countr+ 5internal groth6.
ii. Through the acquisition of e,isting foreign firms 5e,ternal
groth6.
1. $n quantitative terms2 acquisitions are much larger then the
construction of ne facilities abroad.
-. /ergers are difficult to evaluate.
i. The financial managers must be careful to define benefits.
ii. The financial manager needs to understand h+ mergers occur and
ho gains or loses as a result of them.
iii. The acquisition of a compan+ is more complicated than the
purchase of a ne machine because special ta,2 legal2 and
accounting issues must often be addressed.
iv. The integration of an entire compan+ is much more comple, then
the installation of a single ne machine.
). Terminologies.
i. % merger is a transaction that combines to companies into one
ne compan+.
ii. %n acquisition is the purchase of one firm b+ another firm.
iii. &ften the to terms are used interchangeabl+.
Corporate Strategy and Foreign Direct Investment 234
1. There are to parties classifies as the acquiring compan+
5bidder2 initiates the offer6 and acquired compan+ 5target2
receives the offer6.
iv. %cquisitions can be friendl+ or hostile2 depending on hether the
acquiring compan+ b+passes the target compan+@s management or
not.
v. % tender offer is an offer to bu+ a certain number of shares at a
specific price and on specific date for cash2 stoc3 or a combination
of both.
(. /ergers and )orporate Aovernance
i. $n the !.".2 management is much more li3el+ to be disciplined
through either friendl+ or hostile ta3eovers.
ii. $n #apan2 corporate ta3eovers are t+picall+ managed from inside
rather than in the public mar3ets b+ the compan+@s main ban32 b+
its business partners2 or b+ both.
1. Beiretsu is a #apanese ord that stands for large2
financiall+ lin3ed groups of companies that pla+ a
significant role in the countr+@s econom+.
a. %n inner circle of managers2 their ban3ers2 and their
business partners2 therefore2 dominates governance.
2. )ross-holdings have been ea3ened in #apan because the+
have turned from benefit to burden. The+ have depressed
corporate returns on equit+2 loc3ed in outdated business
alliance2 and hampered the formation of more forard-
loo3ing ones.
8. 'or accounting purposes mergers can be treated as either a pooling of
interest or a purchase of assets.
i. !nder the pooling of interest method2 the items on the balance
sheets of the to companies are added together so that the merger
ill not create goodill.
1. 'irms ith intangible assets prefer this method.
ii. !nder the purchase of assets method 5required if the merger is
made ith cash62 the acquired assets or companies are usuall+
recorded in the accounts of the acquiring compan+ at the mar3et
value of assets given in e,change.
1. This is not popular because it generates goodill and this
results in loer reported earnings for several +ears.
'. % ne cross-border merger movement happened in the 1CC*s.
i. The orldide financial communit+ has seen a boom in proposed
or completed mergers2 bu+outs2 and hostile ta3eovers.
ii. Toda+2 there are fe barriers on the scope and locations of mergers
and acquisitions.
1. This is due to rapid advances in technolog+.
iii. The &rgani1ation for 8conomic )ooperation and (evelopment
offer the folloing reasons for the / D % boom in the 1CC*s.
1. &perational s+nergies.
Corporate Strategy and Foreign Direct Investment 235
2. % change in some countries@ attitude toard ta3eovers2
especiall+ hostile ones.
3. The soaring stoc3 mar3et that gave companies currenc+ to
use in acquisitions.
4. The introduction of the euro2 hich reduced transaction
costs and eliminated intra-8uropean currenc+ ris3s.
A. /otives for cross-border mergers and acquisitions.
i. The acquisition of another firm is economicall+ justified onl+ if its
increase the total value of the firm. The traditional approach to the
valuation of the firm consists of four basic steps.
1. (etermine the earnings after ta,es the compan+ e,pects to
produce over the +ears or earnings before ta,es multiplied
b+ 51 7 ta, rate6.
2. (etermine the capitali1ation rate 5discount rate6 for these
earnings.
3. (etermine the e,tent to hich the compan+ ma+ be
leveraged or the adequate amount of debt.
4. )ompute the total value of the firm from the folloing
formula. ?alue of 'irm E 8arnings -efore Ta,es 51 7 Ta,
Fate6
)apitali1ation Fate
4. Ta, and %ccounting $ssues.
i. 8arnings before ta,es. a merger itself creates a larger ph+sical si1e
and opportunities for a s+nergistic effect. The s+nergistic effects
of business mergers are certain economies of scale from the firm@s
loer overhead.
1. The merger allos the firm to acquire necessar+
management s3ills and to spread e,isting management
s3ills over a larger operation.
2. The merger creates opportunities to eliminate duplicate
facilities and to consolidate the functions of production2
mar3eting2 and purchasing.
3. The merger enables the firm to enjo+ greater access to
financial mar3ets and thus to raise debt and equit+ and
loer the cost of capital.
ii. Ta, considerations. The ta, benefits for mergers comes form the
fact that the ta, loss carr+forard e,pires at the end of a certain
number of +ear unless the firm ma3es sufficient profits to offset it
completel+. There are to situations hen mergers could actuall+
avoid corporate income ta,es.
1. When a profitable compan+ acquires companies ith a
large ta, loss carr+forard2 it can reduce its effective ta,
rate and consequentl+ increase its net operating income
after ta,es.
2. % compan+ ith a ta, loss carr+forard ma+ acquire
profitable companies in order to use its carr+foard.
Corporate Strategy and Foreign Direct Investment 236
iii. %ccounting and ta, las ma+ create even more competitive
advantage for acquiring firms in some countries.
1. 'or e,ample2 mergers can create goodill and in some
countries goodill does not affect the acquiring compan+@s
earnings2 but in some countries it does.
$. )apitali1ation Fate. an important advantage of mergers is the fact that
earnings of larger companies are capitali1ed at loer rates. The securities
of larger companies have better mar3etabilit+ than those of smaller
companies.
1. )onsequentl+2 the value of the acquiring firm ma+ e,ceed
the values of the companies operating separatel+.
2. % potential benefit of international acquisition is the loer
required rate of return for the acquiring compan+ due to
different cost of capital in different countries.
#. (ebt )apacit+. There are to situations here a merger can raise the debt
capacit+ for the acquiring compan+ above the sum of debt capacities for
the individual firms prior to the merger.
i. There are companies that fail to ma3e optimum use of debt.
ii. $t is frequentl+ possible for the acquiring compan+ to borro more
than the companies ere able to borro individuall+.
B. % variet+ of other factors affect international acquisitions.
i. 8,change rate movements.
ii. )ountr+ barriers.
iii. "trategic choice.
Key Terms and Concepts
Foreign Direct Investment (FDI) is an investment in either real capital asset or financial
asset ith a minimum of 1*G equit+ onership in a foreign firm.
Equity Alliance is an alliance here one compan+ ta3es a position in another compan+.
Licensing Agreement is an agreement here an /0) 5the licensor6 allos a foreign
compan+ 5the licensee6 to produce its products in a foreign countr+ in e,change for
ro+alties2 fees2 and other forms of compensation.
Franchising agreement is an agreement here an /0) 5franchiser6 allos a foreign
compan+ 5franchisee6 to sell products or services under a highl+ publici1ed brand name
and a ell-proven set of procedures.
Contract Manufacturing occurs hen /0)s contract ith a foreign manufacturer to
produce products for them according to their specifications.
Merger is a transaction that combines to companies into one ne compan+.
Corporate Strategy and Foreign Direct Investment 237
Acquisition is the purchase of one firm b+ another firm.
Tender offer is an offer to bu+ a certain number of shares at a specific price and on a
specific date for cash2 stoc32 or a combination of both.
eiretsu is a #apanese ord hich stands for large2 financiall+ lin3ed groups of
companies that pla+ a significant role in the countr+Hs econom+.
!nder the !ooling"of"interest method2 the items on the balance sheets of the to
companies are added together so that the merger ould not create goodill.
!nder the !urchase"of"assets method2 the acquired assets or companies are usuall+
recorded in the accounts of the acquiring compan+ at the mar3et value of assets given in
e,change.
#ynergistic Effects of business mergers are certain economies of scale from the firmHs
loer overhead.
Multiple Choice Questions
1. The !.". (epartment of )ommerce defines foreign direct investment as investment in
either IIIII.
%. equit+ or leveraged investments
-. equit+ investments alone or investments in a multinational compan+
). a multinational compan+ or in a subsidiar+ of that multinational compan+
(. nominal capital assets or financial assets ith a minimum of ten percent equit+
onership in a foreign firm
8. real capital assets or financial assets ith a minimum of ten percent equit+
onership in a foreign firm
2. /odes of foreign direct investments do not include the folloing .
%. construction of ne plants abroad
-. "ales of airplanes to foreign customers
). mergers and acquisitions of foreign firms
(. international joint ventures
8. international equit+ alliances
3. /an+ multinational companies invest their capital abroad IIIII.
%. because their subsidiaries desperatel+ need those funds
-. to utili1e their oligopol+-created advantages
). to under-utili1e their oligopol+-created advantages
(. because of almost no competition in foreign countries
8. as a reminder of their international outloo3
4. 4ost countries can benefit from foreign direct investment because it IIIII.
Corporate Strategy and Foreign Direct Investment 238
%. contributes to ta, revenues and helps balance their international balance of
pa+ments
-. provides local or3ers ith an opportunit+ to learn managerial s3ills
). induces the transfer of technolog+ and s3ills hich are frequentl+ in short suppl+
(. increases both national emplo+ment and domestic ages
8. all of the above
5. )onstruction of ne plants abroad requires demand forecast. "uch a demand forecast
does not depend on the folloing III.
%. political s+stem
-. competition
). income
(. population
8. economic conditions
>. Total private flos to developing countries gre more than III fold beteen 1CC2
and 1CCC.
%. eight
-. nine
). ten
(. eleven
8. telve
<. 9ocal companies often control the channels of distribution2 the financial resources2
and the mar3eting 3no-ho2 but the+ IIIII.
%. do not have competent managers to efficientl+ run dail+ operations
-. do not have access to ra materials
). do not have the products for mar3eting to capitali1e on their unique mar3et
position
(. need the support and e,perience of multinational companies
8. are overhelmed b+ the strength of multinational companies
=. 9i3e all aspects of good business2 successful licensing requires IIIII.
%. good luc3
-. management and planning
). heav+ investment in capital mar3ets
(. a bureaucratic hierarch+
8. support from a multinational compan+
C. "ince the mid-1CC*s2 III has become the largest component of e,ternal financing to
developing countries.
%. ban3 financing
-. official flos
). bond financing
(. foreign direct investments
8. equit+ financing
Corporate Strategy and Foreign Direct Investment 239
1*. Which of the folloing statements is falseJ
%. a merger is a transaction that combines to companies into one ne compan+.
-. an acquisition is the purchase of one firm b+ another firm.
) a tender offer is an offer to sell a certain number of shares.
(. Beiretsu is a #apanese ord that stands for financiall+ lin3ed groups of firms.
8. cross-holdings in #apan have recentl+ ea3ened.
11. The use of the purchase-of-assets method in case of a merger creates III.
%. goodill
-. actual profits
). additional e,penses
(. additional sales
8. additional mar3et share
12. 0eman said that a groth-oriented compan+ can globall+ close several t+pes of
groth gaps beteen its sales potential and its current actual performance. These
gaps do not include III.
%. a product-line gap
-. a distribution gap
). a local gap
(. a usage gap
8. a competitive gap
13. $mplications of increased private-investment flos include IIIII.
%. broader choices and higher returns for investors
-. higher orld-ide interest rates
). hindering some capital flos to industrial countries
(. all of the above
8. none of the above
14. Which of the folloing is not an oligopol+-created advantage of foreign investment
for investing firmsJ
%. proprietar+ technolog+
-. management 3no-ho
). access to scarce ra materials
(. all of the above
8. political advantage
15. % merger can affect the folloing e,cept III.
%. earnings before ta,es
-. emplo+ee health care
). ta,es
(. capitali1ation rate
8. debt capacit+
Corporate Strategy and Foreign Direct Investment 240
1>. % compan+Hs acquisition of another firm is economicall+ justified onl+ if IIIII.
%. the bought out firm is undervalued
-. it improves cash flo
). the mar3et of the ne compan+ is increased
(. it increases the total value of the firm
8. it is bought on an all cash basis
1<. The appropriate mi, of debt and equit+ III the overall cost of capital.
%. increase
-. reduce
). does not change
(. un3non
8. % and -
1=. The economic c+cles of different countries IIIII.
%. are tied to the correlation of multinational companies or3ing in those countries
-. are required to be uns+nchroni1ed
). tend to be the mostl+ s+nchroni1ed
(. tend to be totall+ s+nchroni1ed
8. do not tend to be totall+ s+nchroni1ed
1C. The ta, benefit for mergers comes from the fact that the ta, loss carr+forard IIIII
unless the firm ma3es sufficient profits to offset it completel+.
%. does not e,pire at an+ moment
-. e,pires at the end of ten +ears in the !nited "tates
). e,pires at the end of a specified number of +ears
(. cannot e,pire during the first five +ears in #apan
8. none of the above
2*. When a profitable compan+ acquires companies ith a large ta, loss carr+forard2
the merger IIIII.
%. increases its net operating income after ta,es
-. decreases its net operating income after ta,es
). increases its net operating income before ta,es
(. decreases its net operating income before ta,es
8. neither decreases nor increases it nets operating income before ta,es
21. 'oreign companies ith more favorable accounting and ta, las IIIII bid higher
prices for target companies.
%. ala+s
-. cannot
). ma+ be able to
(. ma+ not be able to
8. none of the above
22. %n important advantage of mergers is the fact that IIIII.
Corporate Strategy and Foreign Direct Investment 241
%. increased productivit+ is guaranteed in larger companies
-. larger companies acquire a greater ta, advantage
). smaller companies acquire a greater ta, advantage
(. earnings of smaller companies are capitali1ed at loer rates
8. earnings of larger companies are capitali1ed at loer rates
23. The potential benefit of international acquisition is the IIIII.
%. greater ta, base of the nel+ acquired compan+
-. guaranteed larger rate of return for the acquiring compan+
). loer required rate of return for the acquiring compan+
(. guaranteed loer required rate of return for the bought-out compan+
8. guaranteed larger rate of return for the bought-out compan+
24. The appropriate mi, of debt and equit+ reduces the overall cost of capital and
therefore IIIIII.
%. raises the boo3 value of the firm
-. raises the mar3et value of the firm
). loers the mar3et value of the firm
(. loers the boo3 value of the firm
8. raises the mar3et and boo3 value of the firm
25. 'actors affecting international acquisitions e,clude IIIII.
%. smaller ta,es
-. greater ta,es
). higher earnings after ta,es
(. loer capitali1ation rate
8. higher earnings before ta,es
2>. The mar3et-based s+stem of corporate governance is primaril+ used in III.
%. "outh %frica
-. the !nited "tates
). #apan
(. /e,ico
8. )hina
2<. The ban3-based s+stem of corporate governance is primaril+ used in III.
%. #apan
-. the !nited "tates
). the !nited Bingdom
(. )anada
8. 0orth %merica
2=. To major reasons for the continuous groth of foreign direct investment in
developing countries areIII.
%. high ages and highl+ s3illed or3ers
-. various incentive programs and high ages
Corporate Strategy and Foreign Direct Investment 242
). mar3et-based capitalism and lo ages
(. productivit+ and ta, concessions
8. various incentive programs and emerging mar3et-based capitalism
2C. Which of the folloing is not a step for determining the value of a firm.
%. determine the earnings after ta,es the compan+ e,pects to produce
-. determine the capitali1ation rate for the compan+@s earnings
). determine the e,tent to hich the compan+ ma+ be leveraged or the adequate
amount of debt
(. determine the li3elihood of increased or decreased debt
8. determine earnings before ta,es multiplied b+ 51 7 ta, rate6
3*. Which of the folloing is not true of foreign direct investment in developing
countries.
%. )hina receives more '($ than the !nited "tates
-. 9atin %merican and the )aribbean have seen a decrease in investment
). "outh %merica receives the greatest amount of '($
(. the process of privati1ation has moved to completion in man+ developing
countries
8. there has been decline in investment in developing countries
Answers
/ultiple )hoice Kuestions
1. 8 11. % 21. )
2. - 12. ) 22. 8
3. - 13. ( 23. )
4. 8 14. 8 24. -
5. % 15. - 25. -
>. ) 1>. ( 2>. -
<. ) 1<. - 2<. %
=. - 1=. 8 2=. 8
C. ( 1C. ) 2C. (
1*. ) 2*. % 3*. )
Corporate Strategy and Foreign Direct Investment 243