fdi eunresnick chap15
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INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICKSecond Edition
15
Chapter Fifteen
Foreign Direct
Investment
Chapter Objective:
This chapter discusses various issues associated with
foreign direct investments by MNCs, which play a
key role in shaping the nature of the emerging global
economy.
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Chapter Outline
Global Trends in FDI
Why Do Firms Invest Overseas?
Cross-Border Acquisitions Political Risk and FDI
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Global Trends in FDI
Foreign Direct Investment often involves the
establishment of production facilities abroad.
Greenfield Investment Involves building new facilities from the ground up.
Cross-Border Acquisition Involves the purchase of existing business.
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Global Trends in FDI
Several developed nations are the sources of FDI
outflows. About 90% of total world-wide FDI comes from the
developed world.
Both developing anddeveloped nations are the
recipient of inflows of FDI.
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Average Annual FDI (in Billions)
0
20
40
60
80
100
120
AustraliaCa
nada ChinaFrance
Germany Italy JapanM
exico
Netherlands Spain
Sweden
Switz
erland
Unite
dKi
ngdom
Unite
dStates
Inflows
Outflows
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Why Do Firms Invest Overseas?
Trade Barriers
Labour Market Imperfections
Intangible AssetsVertical Integration
Product Life Cycle
Shareholder Diversification
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Trade Barriers
Government action leads to market imperfections.
Tariffs, quotas, and other restrictions on the free
flow of goods, services and people. Trade Barriers can also arise naturally due to high
transportation costs, particularly for low value-to-
weight goods.
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Labour Market Imperfections
Among all factor markets, the labor market is the
least perfect. Recall that the factors of production are land, labor,
capital, and entrepreneurial ability.
If there exist restrictions on the flow of workers
across borders, then labor services can be
underpriced relative to productivity. The restrictions may be immigration barriers or simply
social preferences.
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Labour Market Imperfections
Country Hourly Cost
Germany $27.37
Japan $21.38
France/U.S. $17.10
Israel $9.06
Taiwan $5.47
Mexico $2.57
Persistent wage
differentials across
countries exist.
This is one on the
main reasons
MNCs are making
substantial FDIs inless developed
nations.
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Intangible Assets
Coca-Cola has a very valuable asset in its closely
guarded secret formula.
To protect that proprietary information, Coca-
Cola has chosen FDI over licensing.
Since intangible assets are difficult to package and
sell to foreigners, MNCs often enjoy a
comparative advantage with FDI.
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Vertical Integration
MNCs may undertake FDI in countries where
inputs are available in order to secure the supply
of inputs at a stable accounting price.
Vertical integration may be backward or forward: Backward: e.g. a furniture maker buying a logging
company.
Forward: e.g. a U.S. auto maker buying a Japanese autodealership.
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Product Life Cycle
U.S. firms develop new products in the developed
world for the domestic market, and then markets
expand overseas.
FDI takes place when product maturity hits and
cost becomes an increasingly important
consideration for the MNC.
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Product Life Cycle
Quantity
Quantity
The U.S.
Less advanced
countries
production
New product Maturing product Standardized product
New product Maturing product Standardized product
exports
consump
tion
consump
tion
imports
production
imports
exports
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Shareholder Diversification
Firms may be able to provide indirect
diversification to their shareholders if there exists
significant barriers to the cross-border flow of
capital.
Capital Market imperfections are of decreasing
importance, however.
Managers can therefore probably not add value by
diversifying for their shareholders as the
shareholders can do so themselves at lower cost.
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Cross-Border Acquisitions
Greenfield Investment Building new facilities from the ground up.
Cross-Border Acquisition Purchase of existing business. Cross-Border Acquisition represents 40-50% of FDI
flows.
Cross-border acquisitions are a politicallysensitive issue: Greenfield investment is usually welcome. Cross-border acquisition is often unwelcome.
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Political Risk and FDI
Unquestionably this is the biggest risk when
investing abroad.
Does the foreign government uphold the rule of
law? is a more important question than normative
judgements about the appropriateness of the
foreign governments existing legislation.
A big source of risk is the non-enforcement of
contracts.
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Political Risk and FDI
Macro Risk All foreign operations put at risk due to adverse
political developments.
Micro Risk Selected foreign operations put at risk due to adverse
political developments.
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Political Risk
Transfer Risk Uncertainty regarding cross-border flows of capital.
Operational Risk Uncertainty regarding host countries policies on firms
operations.
Control Risk Uncertainty regarding expropriation.
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Hedging Political Risk
Geographic diversification Simply put, dont put all of your eggs in one basket.
Minimize exposure Form joint ventures with local companies.
Local government may be less inclined to expropriate assetsfrom their own citizens.
Join a consortium of international companies to
undertake FDI.Local government may be less inclined to expropriate assets
from a variety of countries all at once.
Finance projects with local borrowing.
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End Chapter Fifteen
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