chapter 18 foreign direct investment and international capital budgeting
TRANSCRIPT
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Chapter 18
Foreign Direct Investment and International Capital Budgeting
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Objectives
• To discuss the characteristics and development of FDI.
• To outline the theories of FDI.• To describe the techniques of
international capital budgeting.• To examine the implications of
taxation, country risk and transfer prices for international capital budgeting.
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Definition
• An investment project is classified as direct investment if the investor acquires ‘significant control’ over a firm.
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What is ‘Significant Control’ ?
• Ownership of 10-25%• United States, Japan and Australia:
10%• France, Germany and United Kingdom:
higher threshold• Belgium and the Netherlands: no
specific number
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Reasons for Interest in FDI
• Rapid growth and changing pattern of FDI
• Concern about causes and consequences of foreign ownership
• FDI channels resources to developing countries
• The role played in transforming ex-communist countries
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FDI in the Nineteenth Century
• FDI was prominent, but it mostly took the form of lending by Britain to other countries.
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FDI in the Interwar Period
• Foreign investment declined, but direct investment rose.
• Britain lost its status as the major creditor.
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FDI in the Post-World War II Period
• FDI started to grow for two reasons: Improvements in transport and
telecommunications Need of European countries and Japan for
US assistance
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FDI in the 1960s
• Reversal of trend: Host countries started to show resistance
to US ownership of enterprises Host countries started to recover,
initiating FDI in the United States
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FDI in the 1970s
• Lower FDI flows• The United Kingdom appeared as a
major player
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FDI in the 1980s
• The United States became a net debtor.
• Japan emerged as a major source of FDI.
• The surge in FDI was due to the globalisation of business.
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FDI in the 1990s
• FDI declined in 1990-1992 but rebounded subsequently because: FDI is no longer confined to large firms The sectoral diversity of FDI has
broadened The number of countries involved has
risen
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FDI in the 1990s (cont.)
• The decline in the importance of Japan as a source of FDI
• The late 1990s were characterised by the rising popularity of cross-border mergers and acquisitions (M&As)
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Inward and Outward FDI
• Inward FDI is when a foreign country invests in the country in question.
• Outward FDI is when the home country invests abroad.
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FDI Flows
• Equity capital• Reinvested earnings• Intra-company loans
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FDI Stocks
• The value of capital and reserves (including retained earnings) attributable to the parent firm, plus the net indebtedness of its subsidiaries
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Australian FDI Flows (USD Billion)
-4
-2
0
2
4
6
8
10
12
14
1990-95 1996 1997 1998 1999 2000 2001
Inflows Ouflows
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Australian FDI Stocks (USD Billion)
0
20
40
60
80
100
120
1980 1985 1990 1995 2000 2001
Inward Outward
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Cross-Border Mergers and Acquisitions
0
200
400
600
800
1000
1200
1400
1987 1989 1991 1993 1995 1997 1999 2001 2003
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Modes of Foreign Market Entry
• Export of the goods produced in the source country
• Licensing a foreign company to use technology
• Foreign distribution of products through a subsidiary
• Foreign (international) production
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Choice Between Exporting and FDI
• Profitability • Opportunities for market growth• Production cost levels• Economies of scale
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Licensing
• This involves the supply of technology and know-how or the use of a trademark or a patent for a fee.
• It offers one way to generate revenue from foreign markets that are otherwise inaccessible.
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Franchising
• Companies with brand-name products move offshore by granting foreigners the exclusive right to sell their products in a designated area.
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Types of FDI
• Greenfield investment• Brownfield investment• Mergers and acquisitions• Joint ventures
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Choice Between Greenfield Investment and M&As
• Firms with lower R&D intensity, more diversified firms and large multinationals are more inclined to indulge in M&As.
• Inter-country cultural and economic differences reduce the tendency for M&As.
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Choice Between Greenfield Investment and M&As (cont.)
• Multinationals with subsidiaries prefer acquisitions.
• The tendency for M&As depends on the supply of target firms.
• Slow growth in an industry encourages M&As.
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Theories of FDI
• A number of theories or hypotheses have been put forward to explain FDI.
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The Differential Rates of Return Hypothesis
• Capital flows from countries with low rates of return to countries with high rates of return.
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The Diversification Hypothesis
• The choice among various projects is determined by expected return and risk.
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The Output and Market Size Hypothesis
• The volume of direct investment in one host country depends on sales or market size.
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The Industrial Organisation Hypothesis
• A firm indulges in FDI despite inter-country differences because it has some advantages such as brand name, patent, managerial skills, etc.
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The Internalisation Hypothesis
• FDI arises from efforts by firms to replace market transactions with internal transactions.
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The Location Hypothesis
• FDI exists because of the international immobility of some factors of production.
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The Eclectic Theory
• Three conditions must be satisfied if a firm is to engage in FDI: It must have comparative advantages It is better to use rather than lease these
advantages It is more profitable to use these
advantages with factor inputs abroad
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The Product Life Cycle Hypothesis
• When a product is standardised, the innovator may decide to invest in developing countries to obtain some advantages, such as cheap labour.
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The Oligopolistic Reaction Hypothesis
• FDI by one firm triggers similar investment by other leading firms in an attempt to maintain market share.
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The Internal Financing Hypothesis
• FDI is determined by the foreign subsidiaries’ internally generated funds.
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The Currency Areas Hypothesis
• Countries with strong currencies tend to be sources of FDI.
• Countries with weak currencies tend to be recipients of FDI.
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Diversification with Barriers to Capital Flows
• FDI arises from the desire to diversify through two conditions: Barriers or costs to portfolio flows Multinationals provide diversification
opportunities
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Political Stability and Risk
• Lack of political stability discourages FDI inflows.
• Political risk arises because of unexpected modifications of the legal and fiscal framework in the host country.
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Tax Policies
• Tax policies affect incentives to engage in FDI because: Tax treatment of income generated
abroad affects the rate of return Tax treatment of income generated at
home affects relative profitability Tax policies affect the relative cost of
capital
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Government Regulations
• Regulations may provide incentives (e.g. tax credits and exemptions).
• Regulations may provide disincentives
(e.g. slow processing of required authorisation).
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Strategic and Long-term Factors
• The desire to defend foreign markets against competitors
• The desire to gain and maintain a foothold in a protected market
• The need to develop a parent-subsidiary relationship
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Strategic and Long-term Factors (cont.)
• The desire to induce the host country into a long-term commitment to a particular type of technology
• The advantage of complementing another type of investment
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Strategic and Long-term Factors (cont.)
• The economies of new product development
• Competition for market shares among oligopolists
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Evaluating Direct Investment Projects
• Accounting rate of return • Payback period• Net present value (NPV)• Internal rate of return (IRR)
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Accounting Rate of Return
• This is the percentage return on capital.
• The method is criticised because: It is based on profit rather than cash
flows. It ignores the size of the project and the
time value of money.
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Payback Period
• This measures how quickly the cost is recovered.
• It is based on cash flows.• It ignores the time value of money and
the cash flows arising after the payback period.
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Net Present Value
DE
n
tt
t
rDE
Dr
DEE
r
r
CCNPV
1
0 )1(
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Internal Rate of Return
0)1(1
0
n
tt
t
r
CC
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Adjusting Project Assessment for Risk
• Risk-adjusted discount rate• Risk-adjusted cash flows• Sensitivity analysis
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Evaluating FDI Projects
• Two problems: Measurement of cash flows Choice of discount rate
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Problems of Cash Flow Measurement
• Cash flows accruing to the parent company and the subsidiary are different because: Different tax rates Restrictions on remittances Excessive remittances Changes in exchange rates
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Forecasting Cash Flows
• Demand for the product • Price of the product • Variable costs• Fixed costs• Project lifetime
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Forecasting Cash Flows (cont.)
• Salvage value • Remittance restrictions• Tax rates and laws• Exchange rates
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The Evaluation Process
• Estimating incremental cash flows • Estimating remittable cash flows in
domestic currency• Incorporating indirect costs and
benefits • Discounting cash flows
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The Cost of Capital
• This is the minimum risk-adjusted rate of return required in order for the investment to be accepted.
• It is used as a discount rate for future cash flows.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Cost of Capital for Multinationals
• This is likely to be different from that of domestic firms because multinationals: Receive preferential treatment Have better access to international capital
markets Are more diversified Have volatile cash flows
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The APV Technique
• The following items are taken into account: Remittable cash flows Tax savings and subsidies Effect on corporate debt capacity Other cash flows
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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International Taxation
• This is the taxation of cross-border transactions.
• Double taxation arises if income earned abroad is taxed at home and abroad.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Approaches to International Taxation
• Classic approach: income received by each taxable entity is taxed.
• Integrated approach: aims at eliminating double taxation by: Taxing undistributed earnings at a higher
rate Imputation tax system
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Types of Taxes
• Corporate income tax• Withholding taxes • Indirect taxes• Import duties• Taxes on FX gains
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Avoiding Double Taxation
• Many countries have bilateral tax treaties with other countries.
• The OECD has developed a model tax convention.
• One way of avoiding double taxation is tax credits.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Tax Havens
• A tax haven is a place where foreigners may receive income or own assets without paying taxes on them.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Country Risk
• This arises because of the possibility of losses due to country-specific economic, political and social events.
• It encompasses political risk and sovereign risk.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Sovereign Risk
• The possibility of losses on claims on foreign governments and their agencies
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Political Risk
• The possibility of losses due to changes in the rules governing FDI, as well as adverse political developments
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Political Risk: Confiscation
• Confiscation does not involve proper compensation.
• Expropriation implies compensation.
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Incorporating Country Risk into Capital Budgeting
• Adjusting expected cash flows or the discount rate
• Measuring the effects of country risk as the value of an insurance policy
• Using option pricing to derive the price of country risk
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Transfer Pricing
• The pricing of goods and services that are bought and sold (transferred) between members of a corporate family
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Setting Transfer Prices
• Tax considerations• Global regulation• Management incentives and
performance evaluation• Marketing considerations and
competition
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Setting Transfer Prices (cont.)
• Risk and uncertainty• Government policies• The interests of joint venture partners• The negotiating power of the
subsidiary