International Corporate Finance

11th Edition
by Jeff Madura

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 13 Direct Foreign Investment
Chapter Objectives

Describe common motives

for initiating foreign direct
investment

Illustrate the benefits of

international diversification
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 Motives for Direct Foreign Investment:
Revenues Related Motives

5 Revenue Related Motives Attract new sources of

demand

Enter profitable markets

Exploit monopolistic
advantages

React to trade restrictions

Diversity Internationally
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 Motives for Direct Foreign Investment:
Revenues Related Motives

Attract new sources of demand

• pursue DFI in countries experiencing economic
growth so that they can benefit from the
increased demand for products and services there

Enter profitable markets

• 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.
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 Motives for Direct Foreign Investment:
Revenues Related Motives (Cont.)

React to trade restrictions

• MNCs may pursue DFI to circumvent
trade barriers

Diversity Internationally
• By diversifying sales (and possibly
even production) internationally, a
firm can make its net cash flows less
volatile.
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 Motives for Direct Foreign Investment:
Costs Related Motives

5 Costs Related Motives Fully benefit from economies

of scale

Use foreign factors of

production

Use foreign raw materials

Use foreign technology

React to exchange rate

movements
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 Motives for Direct Foreign Investment:
Cost Related Motives

Fully benefit from economies of scale

• Lower average cost per unit resulting from
increased production

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.
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 Motives for Direct Foreign Investment:
Cost Related Motives (Cont.)

Use foreign technology

• MNCs use FDI to learn about unique technologies
in foreign countries.
• This technology is then used to improve their own
production processes and increase production
efficiency at all subsidiary plants around the world

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.

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 Benefits of DFI

◼ Though disadvantages of DFI may exist, MNCs can compare

benefits of DFI among countries and use DFI to achieve those
benefits (Exhibit 13.1).
◼ MNCs measure the benefits of DFI by following the steps in
Exhibit 13.2
▪ MNCs apply a multinational capital budgeting process to compare the
benefits and costs of international projects.

▪ This capital budgeting analysis commonly involves international

restructuring and an assessment of risk characteristics in the country
where the proposed projects are to be implemented.

▪ It also requires an assessment of the cost of capital and debt financing

possibilities.

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 Exhibit 13.1 Summary of Motives for Direct Foreign Investment

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 Exhibit 13.2 Steps Taken by MNCs to Determine Whether to
Pursue Direct Foreign Investment

• Review the revenue and cost-related motives for DFI, and

Identify Motives determine which motives may apply

• Identify a particular international project that may be feasible

Capital Budgeting • Estimate the cash flows and the initial investment associated
with that project

International • Assess existing corporate control within the firm and potential
corporate control targets in foreign countries that could be
Corporate Control. acquired

Country Risk • Analyze the country risk of countries where the MNC presently
does business as well as in countries where the MNC plans to
Analysis expand

• Assess the existing capital structure, and determine whether it is

Capital Structure suitable based on the MNC’s existing operations and its ability
to repay debt.

• Assess the existing capital structure, and determine whether it is

Capital Structure suitable based on the MNC’s existing operations and its ability
to repay debt.

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 Exhibit 13.3 Evaluation of Proposed Projects in Alternative
Locations

Merrimack Co., a U.S. firm, plans to invest in a new project in either the United
States or the United Kingdom. Once the project is completed, it will constitute 30
percent of the firm’s total funds invested in itself. The remaining 70 percent of its
investment in its business is exclusively in the United States. Characteristics of
the proposed project are forecasted for a five-year period for both a U.S. and a
British location

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 Exhibit 13.3 Evaluation of Proposed Projects in Alternative
Locations

Invest in US
• 70% of its total funds are invested in
its prevailing U.S. business
• 30% invested in a new project
located in the United States

Invest in UK
• 70% of its total funds are invested in
its prevailing U.S. business
• 30% invested in a new project
located in the UK
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 Expected return of two project

How about the expected

return when this
company invests in UK?
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 Variance of two project

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 Exhibit 13.4 Risk-Return Analysis of International Projects

Conservative MNCS will

probably prefer one that
exhibits low risk (near the
bottom of the frontier).

A more aggressive
strategy would be to
implement a portfolio of
projects that exhibits
risk– return
characteristics such as
those near the top of the
frontier.

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 Exhibit 13.5 Risk-Return Advantage of a Diversified MNC

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 Exhibit 13.6 Comparison of Expected Economic Growth among
Countries: Annual Stock Market Return

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 Host Government View of DFI

◼ 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.
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 Host Government View of DFI: Barriers to FDI

Environmental
barriers
Industry Regulatory
barriers barriers

Red tape Ethical

barriers differences

Protective
barriers FDI Political
instability

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 Host Government View of DFI (Cont.)

◼ Barriers to DFI
a. Protective barriers - agencies may prevent an MNC from
acquiring companies if they believe employees will be laid off.
b. Red tape barriers - procedural and documentation requirements
c. Industry barriers - local firms may have substantial influence on
the government and may use their influence to prevent competition
from MNCs
d. Environmental barriers - building codes, disposal of production
waste materials, and pollution controls.
e. Regulatory barriers - each country enforces its own regulatory
constraints pertaining to taxes, currency convertibility, earnings
remittance, employee rights, and other policies
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 Host Government View of DFI (Cont.)

f. Ethical differences - a business practice that is perceived to be

unethical in one country may be ethical in another.
g. Political instability - if a country is susceptible to abrupt changes in
government and political conflicts, the feasibility of DFI may be
dependent on the outcome of those conflicts.

◼ Government-imposed conditions to engage in DFI

Some governments allow international acquisitions but impose
special requirements on MNCs that desire to acquire a local firm.

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 SUMMARY

▪ MNCs may be motivated to initiate direct foreign investment

in order to attract new sources of demand or to enter markets
where superior profits are possible. These two motives are
normally based on opportunities to generate more revenue in
foreign markets. Other motives for using DFI are typically
related to cost efficiency, such as using foreign factors of
production, raw materials, or technology. In addition MNCs
may engage in DFI to protect their foreign market share, to
react to exchange rate movements, or to avoid trade
restrictions.

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 SUMMARY (Cont.)

▪ International diversification is a common motive for direct

foreign investment. It allows an MNC to reduce its exposure to
domestic economic conditions. In this way, the MNC may be
able to stabilize its cash flows and reduce its risk. Such a goal
is desirable because it may reduce the firm’s cost of financing.
International projects may allow MNCs to achieve lower risk
than is possible from only domestic projects without reducing
their expected returns. International diversification tends to be
better able to reduce risk when the DFI is targeted to countries
whose economies are somewhat unrelated to an MNC’s home
country economy.

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