part 4 long-term asset and liability management

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International Corporate Finance11th Edition

by Jeff Madura

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Part 4 Long-Term Asset and Liability Management


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13 Direct Foreign Investment

Describe common motives for initiating foreign direct investment

Illustrate the benefits of international diversification

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Chapter Objectives


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Motives for Direct Foreign Investment: Revenue Related Motives

Attract new sources of demandMNCs commonly pursue DFI in countries experiencing economic growth so that they can benefit from the increased demand for products and services there.

Enter profitable marketsWhen 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 advantagesFirms possessing resources or skills not available to competing firms may attempt to exploit it internationally.

React to trade restrictionsMNCs may pursue DFI to circumvent trade barriers.

Diversity InternationallyBy diversifying sales (and possibly even production) internationally, a firm can make itsnet cash flows less volatile.


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Motives for Direct Foreign Investment:Cost Related Motives

Fully benefit from economies of scaleLower average cost per unit resulting from increased production.

Use foreign factors of productionLabor and land costs can vary dramatically among countries.

Use foreign raw materialsDevelop the product in the country where the raw materials are located.

Use foreign technology 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

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Benefits of International Diversification

Select foreign projects whose performance levels are not highly correlated over time. (Exhibit 13.3)

Perform diversification analysis of international projects Comparing portfolios along the frontier of efficient projects

(See Exhibit 13.4) Comparing frontiers among MNCs (See Exhibit 13.5)

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Exhibit 13.3 Evaluation of Proposed Projects in Alternative Locations

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Exhibit 13.4 Risk-Return Analysis of International Projects

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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 (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.)

d. Ethical differences - a business practice that is perceived to be unethical in one country may be ethical in another.

e. 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 DFISome 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.

part 4 long-term asset and liability management

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