Lecture 10 - FDI

Chapter Objectives
• Describe common motives for initiating foreign direct investment.

• Illustrate the benefits of international diversification.
• Describe how the host government can encourage DFI with incentives for
MNCs or discourage DFI by imposing barriers.
• Explain how MNCs can assess their potential DFI projects to determine
Lecture 10 which projects should be given serious consideration.
Direct Foreign Investment
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 2
copied or duplicated, or posted to a publicly accessible website, in whole or in part. copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Motives for Direct Foreign Investment (1 of 4) Motives for Direct Foreign Investment (2 of 4)
Revenue-Related Motives Revenue-Related Motives (continued)
• Attract new sources of demand • React to trade restrictions
MNCs commonly pursue DFI in countries experiencing economic growth so MNCs may pursue DFI to circumvent trade barriers.
that they can benefit from the increased demand for products and services • Diversify Internationally
there.
By diversifying sales (and possibly even production) internationally, a firm
• Enter profitable markets can make its net cash flows less volatile.
When similar industries are generating very high earnings in a particular
country, an MNC may decide to sell its own products in those markets.
• Exploit monopolistic advantages
Firms possessing resources or skills not available to competing firms may
attempt to exploit it internationally.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 3 Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 4
Motives for Direct Foreign Investment (3 of 4) Motives for Direct Foreign Investment (4 of 4)
Cost Related Motives Comparing Benefits of DFI among Countries
• Fully benefit from economies of scale • Though disadvantages of DFI may exist, MNCs can compare benefits of
Lower average cost per unit resulting from increased production. DFI among countries and use DFI to achieve those benefits. (Exhibit 13.1)
• Use foreign factors of production
Labor and land costs can vary dramatically among countries.
• Use foreign raw materials
Develop the product in the country where the raw materials are located.
• Use foreign technology
• React to exchange rate movements
When a firm perceives that a foreign currency is undervalued, the firm may consider DFI in
that country, as the initial outlay should be relatively low.
Exhibit 13.1 Summary of Motives for Direct Foreign Exhibit 13.1 Summary of Motives for Direct Foreign
Investment (1 of 2) Investment (2 of 2)
BENEFIT MEANS OF USING DFI TO ACHIEVE THIS BENEFIT
BENEFIT MEANS OF USING DFI TO ACHIEVE THIS BENEFIT
Cost-Related Motives
Revenue-Related Motives
6. Fully benefit from Establish a subsidiary in a new market that can sell products produced
1. Attract new sources of demand. Establish a subsidiary or acquire a competitor in a new market. economies of scale. elsewhere; this allows for increased production and possibly greater
2. Enter markets where superior Acquire a competitor that has control of its local market. production efficiency.
profits are possible. 7. Use foreign factors of Establish a subsidiary in a market that has relatively low costs of labor or
3. Exploit monopolistic advantages. Establish a subsidiary in a market where competitors are unable to production. land; sell the finished product to countries where the cost of production is
produce the identical product; sell products in that country. higher.
4. React to trade restrictions. Establish a subsidiary in a market where tougher trade restrictions 8. Use foreign raw materials. Establish a subsidiary in a market where raw materials are cheap and
will adversely affect the firm's export volume. accessible; sell the finished product to countries where the raw materials
5. Diversify internationally. Establish subsidiaries in markets whose business cycles differ are more expensive.
from those where existing subsidiaries are based. 9. Use foreign technology. Participate in a joint venture in order to learn about a production process or
other operations.
10. React to exchange rate Establish a subsidiary in a new market where the local currency is weak
movements. but is expected to strengthen over time.
Benefits of International Diversification (1 of 2) Exhibit 13.2 Evaluation of Proposed Projects in
Alternative Locations
Select foreign projects whose performance levels are not highly correlated over
time. (Exhibit 13.2) CHARACTERISTICS CHARACTERISTICS
CHARACTERISTICS OF PROPOSED OF PROPOSED
OF PROPOSED PROJECT PROJECT
 p2  w A2 A2  w B2 B2  2w Aw B A BCORRAB PROJECT OF IF LOCATED IN OF IF LOCATED IN
OF EXISTING THE UNITED THE UNITED
BUSINESS STATES KINGDOM
Mean expected annual return on investment (after 20% 25% 25%
w = proportion of total funds in investments A or B taxes)
σ = standard deviation of returns on investments A or B Standard deviation of expected annual after-tax .10 .09 .11
returns on investment
CORR = correlation coefficient of returns A and B Correlation of expected annual after-tax returns on — .80 .02
investment with after-tax returns of prevailing U.S.
business
Benefits of International Diversification (2 of 2) Exhibit 13.3 Risk-Return Analysis of International

Projects
Diversification Analysis of International Projects
• Comparing portfolios along the frontier of efficient projects (See Exhibit 13.3)
• Comparing frontiers among MNCs (See Exhibit 13.4)
Exhibit 13.4 Risk-Return Advantage of a Host Government Impact on DFI
Diversified MNC
Incentives to encourage DFI
• The ideal DFI solves problems such as unemployment and lack of
technology without taking business away from local firms.
• Governments are particularly willing to offer incentives for DFI that will result
in the employment of local citizens or an increase in technology.
Host Government Views of DFI (1 of 2) Host Government Views of DFI (2 of 2)

Barriers to DFI Barriers to DFI
• Protective barriers — Agencies may prevent an MNC from acquiring • Regulatory barriers — Each country enforces its own regulatory constraints
companies if they believe employees will be laid off pertaining to taxes, currency convertibility, earnings remittance, employee
• “Red Tape” barriers — Procedural and documentation requirements rights, and other policies.
• Industry barriers — Local firms may have substantial influence on the • Ethical differences — A business practice that is perceived to be unethical in
government and may use their influence to prevent competition from MNCs one country may be ethical in another.
• Environmental barriers — Building codes, disposal of production waste • Political instability — If a country is susceptible to abrupt changes in
materials, and pollution controls government and political conflicts, the feasibility of DFI may be dependent on
the outcome of those conflicts.
Assessing the Feasibility of Potential DFI (1 of 3) Exhibit 13.5 Assessment by Monterey Co. to Determine
Whether DFI in the Country of Zuva Should Be Considered
A Case Study of Assessing Potential DFI
TYPE OF CHARACTERISTIC DESCRIPTION FOR THE COUNTRY OF ZUVA
Monterey Co. created a facility 20 years ago to produce and sell health care
Existing demand in Zuva for Demand is restricted because of a quota that restricts Monterey's
products in the United States. (Exhibit 13.5) Monterey's products exports to Zuva.
Potential demand in Zuva for Demand would be at least four times higher without the quota. But
Monterey's products the government of Zuva plans to maintain the quota for a long-
term period.
Competition in Zuva for Monterey's Only one local competitor is in the same industry as Monterey Co.
products This competitor is partially owned by Zuva's government.
Labor characteristics in Zuva The sole competitor in Zuva pays very high wages to its
employees and offers very high retirement benefits, which partially
explains why its operating costs are very high.
Government tax incentives The government of Zuva typically offers foreign firms a tax
incentive to establish a local subsidiary that employs its local
citizens. The corporate income tax imposed on income earned in
Zuva is reduced from 25 percent to 15 percent.
Assessing the Feasibility of Potential DFI (2 of 3) Assessing the Feasibility of Potential DFI (3 of 3)
A Case Study of Assessing Potential DFI (Continued) Evaluating DFI Opportunities That Pass the First Screen
Top financial managers meet with government officials in Zuva to address the MNC can apply a general analysis to screen out many of the opportunities so
following questions: that it can focus on a few opportunities that may offer the largest benefits
• Will Monterey be able to obtain a business license to produce and sell its Exhibit 13.6 are listed in an orderly manner and coincide with the order of
health care products in Zuva? topics covered in the next five chapters of this textbook.
• Is the government of Zuva planning to privatize the sole local competitor?
• Does the country of Zuva have specific labor laws that lead to high labor
costs for all companies there?
• Would Zuva’s government allow Monterey a tax break on income earned by
a subsidiary in Zuva?
• Would the government of Zuva want to buy a stake in any subsidiary
established by Monterey?
Exhibit 13.6 Steps Taken by MNCs to Determine Summary (1 of 3)
Whether to Pursue Direct Foreign Investment
• MNCs may be motivated to initiate direct foreign investment in order to
Identify motives. Review the revenue and cost-related motives for DFI, and determine which motives may apply (as explained in
this chapter).
attract new sources of demand or to enter markets where superior profits
Capital budgeting. Identify a particular international project that may be feasible, and estimate the cash flows and the initial
are possible. These two motives are normally based on opportunities to
investment associated with that project. Apply a capital budgeting analysis to determine whether the proposed project is feasible generate more revenue in foreign markets. Other motives for using DFI are
(as explained in Chapter 14). typically related to cost efficiency, such as using foreign factors of
International corporate control. Determine the appropriate corporate control structure to over see any international subsidiaries that
would be created. In addition, assess potential corporate control targets in foreign countries that could be acquired. Apply capital
production, raw materials, or technology. In addition, MNCs may engage in
budgeting analysis to corporate control candidates and to any existing subsidiaries that could be sold (as explained in Chapter 15). DFI to protect their foreign market share, to react to exchange rate
Country risk analysis. Analyze the country risk in countries where the MNC presently does business as well as in countries where movements, or to avoid trade restrictions.
the MNC plans to expand. Incorporate any conclusions from the country risk analysis into the capital budgeting analysis for those
proposed projects in which the country risk may affect cash flows or the cost of financing projects (as explained in Chapter 16).
Capital structure. Assess the capital structure of existing and newly proposed international subsidiaries, and determine whether it is
suitable based on the MNC's existing operations and its ability to repay debt. Estimate the cost of capital that could be obtained to
finance new international projects, and incorporate that estimate into the capital budgeting analysis (as explained in Chapter 17).
Long-term financing. Consider sources of long-term funds in foreign countries that could be used to finance existing or proposed
international projects. Determine whether the MNC needs to revise the financing to hedge exchange rate risk (match loan
repayment currency with cash inflow currency) or to reduce the cost of capital (as explained in Chapter 18).
Summary (2 of 3) Summary (3 of 3)
• International diversification is a common motive for direct foreign • Host governments commonly encourage DFI in its country by offering
investment. It allows an MNC to reduce its exposure to domestic economic incentives to MNCs. However, host governments might also discourage or
conditions. In this way, the MNC may be able to stabilize its cash flows and prevent some forms of DFI that they believe will adversely affect local
reduce its risk. Such a goal is desirable because it may reduce the firm’s competitors or the environment.
cost of financing. International projects may allow MNCs to achieve lower • When an MNC considers a specific form of DFI, it must measure the
risk than is possible from only domestic projects without reducing their potential benefits, including possible diversification benefits and host
expected returns. International diversification tends to be better able to government incentives. It must also consider country barriers that make the
reduce risk when the DFI is targeted to countries whose economies are DFI more risky. If its initial assessment leads to a conclusion that DFI might
somewhat unrelated to an MNC’s home country economy. be worthwhile, it can then apply a capital budgeting analysis to determine
whether DFI is feasible, as described in the following chapter.

Lecture 10 - FDI

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Chapter Objectives

• Describe common motives for initiating foreign direct investment.

Direct Foreign Investment

Benefits of International Diversification (2 of 2) Exhibit 13.3 Risk-Return Analysis of International

Host Government Views of DFI (1 of 2) Host Government Views of DFI (2 of 2)

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