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Part IV

Long-Term Asset and Liability Management

Potential Revision in Host Country Tax Laws or Other Provisions

 
Potential Revision in Host Country Tax Laws or Other Provisions
 

MNC’s Access to Foreign

 
MNC’s Access to Foreign

Financing

 
 
   
Potential Revision in Host Country Tax Laws or Other Provisions MNC’s Access to Foreign Financing International

International Interest Rates on Long-Term Funds

 

Existing Host Country

 

Tax Laws

   

Exchange

 

Rate

 

Projections

Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other
Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other

Estimated

 

Cash Flows of

Multinational Project

 
Estimated Cash Flows of Multinational Project
Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other
Country Risk Analysis
Country Risk
Analysis

MNC’s Cost

 

of Capital

   
Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other
   

Risk Unique to

 

Multinational Project

Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other

Multinational

Capital

Budgeting

Decisions

Part IV Long-Term Asset and Liability Management Potential Revision in Host Country Tax Laws or Other
Required Return on Multinational Project

Required

 

Return on

 

Multinational

Project

13
13

Chapter

Direct Foreign Investment

South-Western/Thomson Learning © 2006

Slides by Yee-Tien (Ted) Fu

Chapter Objectives

Chapter Objectives  To describe common motives for initiating direct foreign investment (DFI); and  To

To describe common motives for initiating direct foreign investment (DFI); and

To illustrate the benefits of international diversification.

Motives for DFI

Motives for DFI MNCs commonly consider DFI because it can improve their profitability and enhance shareholder

MNCs commonly consider DFI because it can improve their profitability and enhance shareholder wealth.

In most cases, MNCs engage in DFI because they are interested in boosting revenues, reducing costs, or both.

Revenue-Related Motives for DFI

Motives Means of Achieving Benefit
Motives
Means of Achieving Benefit

Attract new sources of demand.

Establish a subsidiary or acquire a competitor in a new market.

 Enter profitable markets. Acquire a competitor that has controlled its local market.
 Enter profitable
markets.
Acquire a competitor that has
controlled its local market.

Exploit monopolistic advantages.

Establish a subsidiary in a market where competitors are unable to produce the identical product.

 React to trade restrictions. Establish a subsidiary in a market where trade restrictions will adversely
 React to trade
restrictions.
Establish a subsidiary in a market
where trade restrictions will
adversely affect export volume.

Diversify internationally.

Establish subsidiaries in markets with different business cycles.

Cost-Related Motives for DFI

Motives Means of Achieving Benefit
Motives
Means of Achieving Benefit

Fully benefit from economies of scale.

Establish a subsidiary in a new market where products produced elsewhere can be sold. This allows for increased production and greater production efficiency.

 Use foreign factors of production. Establish a subsidiary in a market that has lower costs
 Use foreign factors
of production.
Establish a subsidiary in a market
that has lower costs of labor or
land. Sell the products elsewhere.

Use foreign raw materials.

Establish a subsidiary in a market where raw materials are cheap and accessible. Sell the products in that market and elsewhere.

Cost-Related Motives for DFI

Motives Means of Achieving Benefit
Motives
Means of Achieving Benefit

Use foreign technology.

Participate in a joint venture or acquire an existing overseas plant to learn about foreign production processes, so as to improve its own operations.

 React to exchange rate movements. Establish a subsidiary in a new market where the local
 React to exchange
rate movements.
Establish a subsidiary in a new
market where the local currency
is weak but is expected to
strengthen over time.

Motives for DFI

Motives for DFI The European Union’s recent expansion enables members to transport products throughout Europe at

The European Union’s recent expansion enables members to transport products throughout Europe at reduced tariffs.

New low-wage members (such as Poland, the Czech Republic and Romania) were thus targeted for new DFI by MNCs that wanted to reduce manufacturing costs.

However, there is a tradeoff – thousands of jobs were lost in Western Europe.

Comparing the Benefits of DFI 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.

Comparing the Benefits of DFI 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 issues.

Comparing the Benefits of DFI Over Time

As conditions change over time, some countries may become more attractive targets for DFI, while other countries become less attractive.

Europe (especially Eastern Europe), Latin America, and Asia now receive a larger proportion of DFI than in the past.

Benefits of International Diversification

Benefits of International Diversification The key to international diversification is to select foreign projects whose performance

The key to international diversification is to select foreign projects whose performance levels are not highly correlated over time.

In this way, the various international projects are less likely to experience poor performance simultaneously.

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.

Characteristics of Proposed Project If Located in in the U.S. in the U.K. Project’s mean expected
Characteristics of Proposed
Project If Located in
in the U.S.
in the U.K.
Project’s mean expected
annual after-tax return
25%
25%
Standard deviation of
project’s return
.09
.11
Correlation of project’s
return with return on
existing U.S. business
.80
.02

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.

Diversification Benefits for Merrimack Co.

Suppose that the 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

2

w σ

A

2

A

2

w σ

B

2

B

2

w

A

w

B

σ σ

A

B

CORR

AB

.70 .10 .008653

2

2

2

.30 .09

2

2 .70



.30



.10



.09



.80

Diversification Benefits for Merrimack Co.

If the new project is located in the U.K., the portfolio variance for the overall firm

2

w σ

A

2

A

2

w σ

B

2

B

2

w

A

w σ

B

σ

A

B

CORR

AB

2

.70 .10

2

2

.30 .11

2

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.

Diversification Analysis of International Projects

Diversification Analysis of International Projects Like any investor, an MNC with projects positioned around the world

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.

Risk-Return Analysis of International Projects

Frontier of efficient project portfolios A B C D Project A has the highest expected return
Frontier of efficient
project portfolios
A
B
C
D
Project A has
the highest
expected
return and
greatest risk.
G
F
E
Expected Return

Risk

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.

Diversification Analysis of International Projects

Diversification Analysis of International Projects Project portfolios along the efficient frontier exhibit minimum risk for a

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.

Diversification Analysis of International Projects

Diversification Analysis of International Projects Some MNCs have frontiers of possible project portfolios that are more

Some MNCs have frontiers of possible project portfolios that are more desirable than the frontiers of other MNCs.

Efficient frontier for a multiproduct MNC Efficient frontier for a single- product MNC Expected Return
Efficient frontier for
a multiproduct
MNC
Efficient frontier
for a single-
product MNC
Expected Return

Risk

Diversification Analysis of International Projects

Diversification Analysis of International Projects Our discussion suggests that MNCs can achieve more desirable risk-return characteristics

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.

Comparison of Economic Growth Among Countries

Decisions Subsequent to DFI

Decisions Subsequent to DFI Some periodic decisions are necessary: ¤ Should further expansion take place? ¤

Some periodic decisions are necessary:

¤ Should further expansion take place?

¤ Should the earnings be remitted to the parent, or used by the subsidiary?

These decisions should be analyzed on a case-by-case basis.

Host Government View of DFI

Each government must weigh the advantages and disadvantages of DFI in its country.

The government may provide incentives to encourage desirable forms of DFI, and impose preventive barriers or conditions on other forms of DFI.

Incentives to Encourage DFI

The ideal DFI 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 energy, and reduced environmental restrictions.

Barriers to DFI

Governments are less anxious to encourage DFI that adversely affects local firms, consumers and the economy.

DFI 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, and political instability.

Government-Imposed Conditions to Engage in DFI

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

Such conditions include environmental constraints, restrictions on local sales, and employment requirements.