CHAPTER THREE

INTERNATIONALINVESTMENT: FOREIGN DIRECT INVESTMENT

The explosive growth of international financial transactions and capital flows is one of the most
far-reaching economic developments of the late 20th century. Powerful forces have driven the
rapid growth of international capital flows, including the trend in both industrial and developing
countries towards economic liberalization and the globalization of trade. Revolutionary changes
in information and communications technologies have transformed the financial services
industry worldwide. Computer links enable investors to access information on asset prices at
minimal cost on a real time basis, while increased computing power enables them to rapidly
circulate correlations among asset prices and between asset prices and other variables.

MNCs commonly capitalize on foreign business opportunities by engaging in direct foreign

investment (DFI), which is investment in real assets (such as land, buildings, or even existing
plants) in foreign countries. They engage in joint ventures with foreign firms, acquire foreign
firms, and form new foreign subsidiaries. Financial managers must understand the potential
return and risk associated with DFI so that they can make investment decisions thatmaximize the
MNC’s value.

Foreign direct investment refers to investment in a foreign country where the investor retains
control over the investment. It typically takes the form of starting a subsidiary, acquiring a stake
in an existing firm or starting a joint venture in the foreign country.

FDI implies that the investor exerts a significant degree of influence on the management of the
enterprise resident in the other country. Flows of FDI comprise capital provided (either directly
or through other related enterprises) by a foreign direct investor to an FDI enterprise, or capital
received from an FDI enterprise by a foreign direct investor.

A useful means to judge whether a foreign investment is desirable is to consider the type of
imperfection that theinvestment is designed to overcome internalization, and hence FDI, is most
likely to be economically viable in those settings where the possibility of contractual difficulties
make it especially costly to coordinate economic activities via arm’s length transactions in the
marketplace. Such “market failure” imperfections lead to both vertical and horizontal direct
investment.
1. Vertical integration directinvestment across industries that relate to different stages of
production of a particular good-enables the MNC to substitute internal production and
distribution systems for inefficient markets. For instance, vertical integration might allow
a firm to install specialized cost-saving equipment in two locations without the worry
and risk that facilities may be idled by disagreements with unrelated enterprises.
2. Horizontal direct investment-investmentthat is cross-border but within industry
enables the MNC to utilize an advantage such as know-how or technology and avoid the
contractual difficulties of dealing with unrelated parties. Examples of contractual
difficulties are the MNC’s inability to price know-how or to write, monitor, and enforce
use restrictions governing technology transfer arrangements. Thus, foreign direct

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 investment makes most sense when firm possesses a valuable asset and is better off
directly controlling use of the asset rather than selling or licensing it.

MOTIVES FOR FOREIGN DIRECT INVESTMENT

A firm seeking to maximize shareholders’wealth may find it is worthwhile to increase their
foreign business. There are several possible motives for a corporation becoming more
internationalized. These are reasons why a parent company might want to set up subsidiary
companies in other countries.
1. Attract new sources of demand:
Corporations often reach a stage where growth is limited intheir home country. This may be due
to intense competition for the product they sell. Thus, possible solution is to consider foreign
markets where there is potential demand.
2. Enter markets where excessive profits are available:
If other corporations within theindustry have proven that excessive earnings can be realized in
other markets, an MNC may also decide to sell in that market. But a problem of barriers to entry
exists such as lowering prices by competitors.
3. Full benefit from economies of scale:
The Corporation that attempts to sell its primaryproduct in new markets may increase its
earnings and shareholders’ wealth due to economies of scale. Such motive is more likely for
firms that utilize much machinery.
4. Use foreign factors of production:
Labor and land costs vary dramatically among countries.MNCs often attempt to set up
production in a location where land and labor are cheap. Due to market imperfections such as
imperfect information, relocation transactions costs, barriers to industry entry by firms etc,
specific labor costs will not necessary become equal among markets.
5. International diversification:
The firm may reduce its cash flow variability by diversifyingits product mix. Any decrease in
net cash flows due to reduced demand for some of its products may be somewhat offset by an
increase in other net cash flows resulting from increased demand for its other products.
6. React to trade restrictions:
In some cases, an MNC uses FDI as a defensive strategy ratherthan aggressive strategy. For
example, Japanese automobile manufacturers established plants in the USA in anticipation that
their exports to the US would be subject to more stringenttrade restrictions.
7. Benefit politically:
Some MNCs based in politically unstable countries attempt to expand inother more stable
countries. In addition, MNCs based in countries with growingsocialism pursue other markets in
which they have greater flexibility to make business decisions. These political motives are
especially applicable to MNCs in LDCs.
8. React to foreign currency’s changing value:
When a foreign currency is perceived by afirm to be undervalued, the firm may consider direct
foreign investment in that country. The initial outlay should be relatively low. If the currency
strengthens over time, the earnings remitted to the parent may increase.
9. Use foreign raw materials.

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Due to transportation costs, a corporation may attempt to avoid importing raw materials from a
given country, especially when it plans to sell the finished product back to consumers in that
country. Under such circumstances, a more feasible solution may be to develop the product in
the country where the raw materials are located.
10. Use foreign technology.
Corporations are increasingly establishing overseas plants or acquiring existing overseas plants
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.

STEPS TAKEN BY MNCS TO DETERMINE WHETHER TO PURSUE DIRECT

FOREIGN INVESTMENT
Multinational corporations (MNCs) undertake a systematic process to evaluate whether to
pursue Foreign Direct Investment (FDI) opportunities. This process typically involves several
steps:
1. Market Research and Analysis
MNCs conduct comprehensive market research and analysis to identify potential foreign
markets that align with their strategic objectives. This includes assessing market size, growth
potential, competition, consumer behavior, regulatory environment, and cultural factors.
2. Risk Assessment
MNCs evaluate the risks associated with entering foreign markets, including political, economic,
legal, and operational risks. This involves assessing factors such as political stability, currency
exchange rates, trade barriers, intellectual property protection, and labor market conditions.
3. Feasibility Study
MNCs conduct a feasibility study to assess the viability of FDI in the target market. This
involves analyzing factors such as investment costs, expected returns, potential obstacles, and
investment payback period. Financial modeling and scenario analysis may be used to evaluate
different investment options and outcomes.
4. Competitive Analysis
MNCs analyze the competitive landscape in the target market to understand the strengths and
weaknesses of existing competitors, as well as potential entry barriers. This involves assessing
factors such as market share, product offerings, pricing strategies, distribution channels, and
brand reputation.
5. Regulatory Compliance
MNCs evaluate regulatory requirements and compliance issues associated with FDI in the target
market. This includes understanding foreign investment regulations, taxation policies, licensing
requirements, labor laws, environmental regulations, and other legal considerations.
6. Strategic Alignment
MNCs assess how FDI in the target market aligns with their overall business strategy, goals, and
objectives. This involves considering factors such as market positioning, product portfolio,
technology transfer opportunities, supply chain optimization, and synergies with existing
operations.
7. Stakeholder Engagement

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MNCs engage with various stakeholders, including government officials, industry associations,
local partners, suppliers, customers, and community representatives, to gather insights, build
relationships, and address concerns related to FDI.
8. Decision Making
Based on the findings from the above steps, MNCs make an informed decision on whether to
pursue FDI in the target market. This decision is typically guided by a comprehensive
assessment of opportunities, risks, costs, benefits, and strategic fit.
9. Implementation Planning
If the decision is made to proceed with FDI, MNCs develop a detailed implementation plan
outlining the steps, timelines, resources, and responsibilities required to establish or expand
operations in the target market. This may involve setting up new facilities, acquiring existing
assets, forming joint ventures or strategic alliances, hiring local talent, and developing marketing
and distribution channels.
10. Monitoring and Evaluation
MNCs continuously monitor and evaluate the performance of FDI initiatives in the target
market, measuring key performance indicators (KPIs) such as sales growth, market share,
profitability, return on investment (ROI), and customer satisfaction. This allows them to identify
areas for improvement, make course corrections, and optimize their international expansion
strategies over time.

THEORIES OF FOREIGN DIRECT INVESTMENT

Certain theories have attempted to address limitations of international trade theories under FDI.
1. The Differential rate of Return Theory
This theory was popular in the late 1950’s. It argues that, if expected marginal revenues are
higher abroad than at home, given the same marginal cost of capital for investment at home and
abroad, there is an incentive to invest abroad. This theory assume that FDI is simply an
international capital movement and it does not recognize that DI is more than that, in addition,
this theory cannot explain why some countries are experiencing simultaneous inflow and out
flows of FDI, and empirical studies have not produced conclusive evidence to support the
theory.
2. The product cycle theory
Employ the notion that most products follow the notion of product life cycle. First, new products
are introduced in the domestic market as innovation and eventually they are completely
standardized, thereby becoming an easier target for competition. FDI takes place as firms, facing
saturation of the domestic market as the product matures, expand overseas and capture the
remaining rents from development of the product. In addition, overseas expansion follows a
certain geographical sequence according to the firms’ familiarity with the markets.
3. The industrial organization theory (monopolistic market theory)
Argues that, despite unfavorable conditions abroad for foreign entrants, multinational firms do
have net advantage in competing against local firms because they have brand name products,
superior technology, market know how, cheaper financial costs and economies of scale.
4. Internationalization Theory
The theory argues that FDI is a result of replacing market transactions with internal transactions.
The need for such replacement arises when the entrant firms face greater imperfections in the

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foreign markets for intermediate inputs. From acquisition of inputs, to the delivery of output to
customers, there are a number of transactions to be performed with outsiders (unaffiliated) units
as well as with insiders (affiliates) of a firm. By replacing outsiders’ transaction with insider
transactions, a firm may reduce transaction costs, particularly when the market is imperfect. The
benefits include avoidance of many stage negotiations, delays and market uncertainty,
minimizing of government intervention through transfer pricing and changes of sourcing and the
ability to exercise discrimination pricing.
5. The currency Area Theory
The theory argues that the pattern of FDI depends on therelative strength of various currencies.
The stronger the currency of a certain country, the more likely is that firm from that country will
invest in the domestic market.The strength of the currency is determined by the size of the
capital market denomination in this currency its exchange rate risks, the extent of over valuation
of the currency and the markets preference for holding assets in the currency. Empirical studies
in line with this hypothesis havefocused on testing whether or over valuation of a currency
country and an under valuation of a currency has caused inflows of DI from abroad.
6. The market area Theory
Postulates that, the market size measured by, either sales volume of the companies or income in
the host country is the source of incentives to make FDI. The available data is in consistent with
this hypothesis in terms of significance of correlation, can also be interpreted to be superfluous.

BARRIERS TO FOREIGN DIRECT INVESTMENT

Governments are less anxious to encourage FDI that adversely affects locally owned companies,
unless they believe that the increased competition is needed to serve consumers. Therefore, they
tend to closely regulate any FDI that may affect local firms, consumers, and economic
conditions.
1. Protective Barriers
When MNCs consider engaging in FDI by acquiring a foreign company, they may face various
barriers imposed by host government agencies. Allcountries have one or more government
agencies that monitor mergers and acquisitions.These agencies may prevent an MNC from
acquiring companies in their country if they believe it will attempt to lay off employees. They
may even restrict foreign ownership ofany local firms.
2. “Red Tape” Barriers
An implicit barrier to FDI in some countries is the “red tape”involved, such as procedural and
documentation requirements. An MNC pursuing DFI issubject to a different set of requirements
in each country. Therefore, it is difficult for anMNC to become proficient at the process unless it
concentrates on FDI within a single foreign country. The current efforts to make regulations
uniform across Europe havesimplified the process required to acquire European firms.
3. Industry Barriers
The local firms of some industries in particular countries have substantial influence on the
government and will likely use their influence to preventcompetition from MNCs that attempt
FDI. MNCs that consider FDI need to recognizethe influence that these local firms have on the
local government.
4. Environmental Barriers

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Each country enforces its own environmental constraints.Some countries may enforce more of
these restrictions on a subsidiary whose parent isbased in a different country. Building codes,
disposal of production waste materials, andpollution controls are examples of restrictions that
force subsidiaries to incur additional costs. Many European countries have recently imposed
tougher antipollution laws as aresult of severe problems.
5. Regulatory Barriers
Each country also enforces its own regulatory constraints pertainingto taxes, currency
convertibility, earnings remittance, employee rights, and other policiesthat can affect cash flows
of a subsidiary established there. Because these regulations caninfluence cash flows, financial
managers must consider them when assessing policies. Also,any change in these regulations
may require revision of existing financial policies, so financial managers should monitor the
regulations for any potential changes over time. Some countries may require extensive
protection of employee rights. If so, managers should attempt toreward employees for efficient
production so that the goals of labor and shareholders will beclosely aligned.
6. Ethical Differences
There is no consensus standard of business conduct thatapplies to all countries. A business
practice that is perceived to be unethical in onecountry may be totally ethical in another. For
example, U.S.based MNCs are wellaware that certain business practices that are accepted in
some less developed countries would be illegal in the United States. Bribes to governments in
order to receive specialtax breaks or other favors are common in some countries. If MNCs do
not participatein such practices, they may be at a competitive disadvantage when attempting DFI
in aparticular country.
7. Political Instability
The governments of some countries may prevent FDI. If a country is susceptible to abrupt
changes in government and political conflicts, the feasibilityof FDI may be dependent on the
outcome of those conflicts. MNCs want to avoid a situationin which they pursue FDI under a
government that is likely to be removed after theFDI occurs.

FACTORS AFFECTING FOREIGN DIRECT INVESTMENT

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1. Wage rates
A major incentive for a multinational to invest abroad is to outsource labour intensive
production to countries with lower wages. If average wages in the US are $15 an hour, but $1 an
hour in the Indian sub-continent, costs can be reduced by outsourcing production. This is why
many Western firms have invested in clothing factories in the Indian sub-continent. However,
wage rates alone do not determine FDI, countries with high wage rates can still attract higher
tech investment. A firm may be reluctant to invest in Sub-Saharan Africa because low wages are
outweighed by other drawbacks, such as lack of infrastructure and transport links.
2. Labour skills
Some industries require higher skilled labour, for example pharmaceuticals and electronics.
Therefore, multinationals will invest in those countries with a combination of low wages, but
high labour productivity and skills. For example, India has attracted significant investment in
call centers, because a high percentage of the population speak English, but wages are low. This
makes it an attractive place for outsourcing and therefore attracts investment.

3. Tax rates
Large multinationals, such as Apple, Google and Microsoft have sought to invest in countries
with lower corporation tax rates. For example, Ireland has been successful in attracting
investment from Google and Microsoft. In fact, it has been controversial because Google has
tried to funnel all profits through Ireland, despite having operations in all European countries.
4. Transport and infrastructure
A key factor in the desirability of investment are the transport costs and levels of infrastructure.
A country may have low labour costs, but if there is then high transport costs to get the goods

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onto the world market, this is a drawback. Countries with access to the sea are at an advantage to
landlocked countries, who will have higher costs to ship goods.
5. Size of economy / potential for growth
Foreign direct investment is often targeted to selling goods directly to the country involved in
attracting the investment. Therefore, the size of the population and scope for economic growth
will be important for attracting investment. For example, Eastern European countries, with a
large population, e.g. Poland offers scope for new markets. This may attract foreign car firms,
e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer
class. Small countries may be at a disadvantage because it is not worth investing for a small
population. China will be a target for foreign investment as the newly emerging Chinese middle
class could have a very strong demand for the goods and services of multinationals.
6. Political stability / property rights
Foreign direct investment has an element of risk. Countries with an uncertain political situation,
will be a major disincentive. Also, economic crisis can discourage investment. For example, the
recent Russian economic crisis, combined with economic sanctions, will be a major factor to
discourage foreign investment. This is one reason why former Communist countries in the East
are keen to join the European Union. The EU is seen as a signal of political and economic
stability, which encourages foreign investment.Related to political stability is the level of
corruption and trust in institutions, especially judiciary and the extent of law and order.
7. Commodities
One reason for foreign investment is the existence of commodities. This has been a major reason
for the growth in FDI within Africa – often by Chinese firms looking for a secure supply of
commodities.
8. Exchange rate
A weak exchange rate in the host country can attract more FDI because it will be cheaper for the
multinational to purchase assets. However, exchange rate volatility could discourage investment.
9. Clustering effects
Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is that
they can benefit from external economies of scale growth of service industries and transport
links. Also, there will be greater confidence to invest in areas with a good track record.
Therefore, some countries can create a virtuous cycle of attracting investment and then these
initial investments attracting more.

10. Access to free trade areas.

A significant factor for firms investing in Europe is access to EU Single Market, which is a free
trade area but also has very low non-tariff barriers because of harmonisation of rules, regulations
and free movement of people. For example, UK post-Brexit is likely to be less attractive to FDI,
if it is outside the Single Market.

DESIGNING A GLOBAL EXPANSION STRATEGY

Although a strong competitive advantage today in, say, technology or marketing skills may give
a company some breathing space, these competitive advantages will eventually erode, leaving
the firm susceptible to increased competition both at home and abroad. The emphasis must be on
systematically pursuing policies and investments congruent with worldwide survival and
growth. This approach involves five interrelated elements.
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 1. Awareness of Profitable Investments
Firms must have an awareness of those investments that are likely to be most profitable. As we
have previously seen, these investments are ones that capitalize on and enhance thefirm’s
differential advantage; that is, an investment strategy should focus explicitly on building
competitive advantage. This strategy could be geared to building volume when economies of
scale are all important or to broadening the product scope when economies of scope are critical
to success. Such a strategy is likely to encompass a sequence of tactical projects; projects may
yield low returns when considered in isolation, but together they may either createvaluable
future investment opportunities or allow the firm to continue earning excess returns on existing
investments. Proper evaluation of a sequence of tactical projects designed to achieve competitive
advantage requires that the projects be analyzed jointly rather than incrementally.
2. Selecting a Mode of Entry
This global approach to investment planning necessitates systematic evaluation of individual
entry strategies in foreign markets, comparison of the alternatives, and selection of the optimal
mode of entry. For example, in the absence of strong brand names or distribution capabilities but
with a labor-cost advantage, Japanese television manufacturers entered the U.S. market
byselling low-cost, private-label black-and-white TVs.
3. Auditing the Effectiveness of Entry Modes
A key element is a continual audit of the effectiveness of current entry modes, bearing in mind
that a market’s sales potential is at least partially a function of the entry strategy. As knowledge
about a foreign market increases or as sales potential grows, the optimal market penetration
strategy will likely change. By the late 1960s, for example, the Japanese television
manufacturers had built a large volume base by selling private-label TVs. Using this volume
base, they invested in new process and product technologies, from which came the advantages
of scale and quality. Recognizing the transient nature of a competitive advantage built on labor
and scale advantages, Japanese companies, such as Matsushita and Sony, strengthened
theircompetitive position in the U.S. market by investing throughout the 1970s to build strong
brand franchises and distribution capabilities. The new-product positioning was facilitated by
large scale investments in R&D. By the 1980s, the Japanese competitive advantage in TVs
andother consumer electronics had switched from being cost based to being based on
quality,features, strong brand names, and distribution systems.
4. Using Appropriate Evaluation Criteria
A systematic investment analysis requires the use of appropriate evaluation criteria. Despite the
complex interactions between investments or corporate policies and the difficulties in evaluating
proposals, most firms still use simple rules of thumb inselecting projects to undertake.
Analytical techniques are used only as a rough screening device or as a final checkoff before
project approval.

Foreign investments are designed to improve the company’s competitive posture elsewhere. For
example, Air Liquide, the world’s largest industrial-gas maker, opened a facility in Japan
because Japanese factories make high demands of their gas suppliers and keeping pace with
them ensures that the French company will stay competitive elsewhere. In the words of the
Japanese unit’s president, ‘‘We want to develop ourselves to be strong wherever our competitors
are.’’ Similarly, a spokesperson said that Air Liquideexpanded its U.S. presence because the

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United States is ‘‘the perfect marketing observatory.’’ U.S. electronics companies and paper
makers have found new uses for the company’s gases, and Air Liquide has brought back the
ideas to European customers.
5. Estimating the Longevity of a Competitive Advantage
The firm must estimate the longevity of its particular form of competitive advantage. If this
advantage is easily replicated, both local and foreign competitors will soon apply the same
concept, process, or organizational structure to their operations. The resulting competition will
erode profits to a point at which the MNC can no longer justify its existence in the market. For
this reason, the firm’s competitive advantage should be constantly monitored and maintained to
ensure the existence of an effective barrier to entry into the market. Should these entrybarriers
break down, the firm must be able to react quickly and either reconstruct them orbuild new ones.

RISKS IN INTERNATIONAL TRADE

Businesses involved in international trade have to deal not just with risks locally but also other
business development which can obstruct the smooth running of the business. Risk happens on
account of uncertainty about happening of an event like loss, damage, variations in foreign
exchange rates, interest rate variations, etc.

The international business faces the risk due to the following reasons:
1. Operations across and with different political, legal, taxation and culture systems.
2. Operations across and with a wider range of product and factor markets, each with
different levels of competition and efficiency.
3. Trades in wider range of currencies and frequent resort to foreign exchange markets.
4. Unregulated international capital markets.

1. Foreign Exchange Rate Risk:

The variance or changes of the real domestic currency value of assets, liabilities or operating
income on account of unanticipated changes in exchange rates referred as Foreign Exchange
Risk. This risk relates to the uncertainty attached to the exchange rates between the two
currencies.

If an Indian businessman borrows some amount viz. dollars and has to repay the loan in dollars
only over a period of time, then he is said to be exposed to the foreign exchange rate risk during
the currency of loan.

Thus, if the dollar becomes stronger (costly) vis-a-vis rupees (cheap) or depreciated during the
period then the businessman has to repay the loan in terms of more rupees than the rupees he
obtained by way of loan. The extra rupees which he pays are not due to an increase of interest
rates, but because of the unfavourable foreign exchange rate.

On the contrary, he gains if the dollar weakens vis-a-vis rupee because of favourable exchange
rate. Anyway, the businessman would like to protect his business from unfavourable exchange
rate by adopting a number of hedging techniques and would like to optimise his gains in case of
favourable exchange rate situation. This mechanism, in short, is known as Foreign Exchange
Risk Management.
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2. Interest Rate Risk:
The fluctuations in interest rates over a period of time change the cash flow need of a firm, for
interest payment. The rate of interest is decided and agreed among parties (i.e. lender and
borrower) at the time of sanctioning of debt. Interest rate uncertainty exposes a firm to the
following types of risks. Borrowings on floating rate bring uncertainty relating to future interest
payments, for the firm. The floating rate makes borrowing cost of capital unknown.
3. Credit Risk:
A credit risk is the risk, in a transaction, of counter party of the transaction failing to meet its
obligation towards the transaction. This risk is present in all trade and commerce transactions,
thus it also includes the transactions relating to foreign trade and foreign exchange.
4. Legal Risk:
The risk arising due to legal enforceability of a contract or a transaction is known as legal risk.
The contract is normally unenforceable due to pending, or newly created, political and legal
issues between the two trading countries. The various legal taxes, controls, regulations,
exchange and trade controls, controls on financial transactions, controls on tariff, and quotas
system, are risks factors or elements in foreign trade and finance flows.
5. Liquidity Risk:
If the markets turn illiquid or the positions in market are such that cannot be liquidated, except
huge price concession, the resultant risk is known as liquidity risk. It can also be termed that the
risks which, though directly or indirectly, affect the liquidity and in turn long term solvency of
the parties in the market, is known as liquidity risk. The international financial system failed to
support the increasing demands of expanding trade and finance due to lack of enough resources,
efficient and quick actions of surveillance on capital flows and inadequate liquidity to meet
emerging crisis situations.
6. Settlement Risk:
This is the risk of counterparty failing during settlement, because of time difference in the
markets in which cash flows the two currencies have to be paid and received viz. settled.
Settlement risk depends on the various risks like risk of the borrowing company’s ability to meet
its debt service obligation in time, represented by the risk of its business, financial risk, market
risk, labour problems, restrictions on dividend distribution, fluctuations in profits and a host of
other company related problems. Unanticipated depreciation of a country’s currency might hurt
a company which is net importer but it may benefit exporter.
7. Political Risk:
Political Risk is the risk that results from political changes or instability in a country. Such
variability or changes always result into some kind of changes in the monetary, fiscal, legal, and
other policies of the country facing the changes. It has adverse impact on the working of the
financial and commercial operation carried out by the country with the globe, and also of foreign
enterprise located in host country. When a factor of instability is found with a country, such kind
of risk crop up, and affect the foreign trade and exchange of the country adversely. The political
risk results in to uncertainty over property rights and protection of wealth.

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