Description
Describe common motives for initiating direct foreign investment (DFI) and to illustrate the benefits of international diversification.
? To describe common motives for initiating
direct foreign investment (DFI); and
? To illustrate the benefits of international
diversification.
Classification 1 :
• Revenue related Motives
• Cost related Motives
Classification 2 :
• Trade Barriers
• Labor Market Imperfections
• Intangible Assets
• Vertical Integration
• Product Life Cycle
• Shareholder Diversification
Revenue related
Motives
Means of using DFI to achieve this
benefit
Attract new sources of
demand
Establish a subsidiary or acquire a
competitor in a new market
Enter markets where
superior profits are
possible
Acquire a competitor that has controlled it’s
local market
Exploit monopolistic
advantages
Establish a subsidiary in a market where
competitors are unable to produce the
identical product: sell products in that
country
React to trade
restrictions
Establish a subsidiary in a market where
tougher trade restrictions will adversely
affect the firm’s export volume
Diversify internationally
Establish a subsidiaries in a market whose
business cycles differ from those where
existing subsidiaries are based
Cost related
Motives
Means of using DFI to achieve this
benefit
Fully benefit from
economies of
scale
Establish a subsidiary in a new market that can sell
products produced elsewhere; this allows for
increased production and possibly greater
production efficiency
Use foreign
factors of
production
Establish a subsidiary in a market that has
relatively low costs of labor or land; sell the
finished product to countries where cost of
production is higher
Use foreign raw
materials
Establish a subsidiary in a market where raw
materials are cheap and accessible; sell the
finished product to countries where the raw
materials are more expensive
Use foreign
technology
Participate in a joint venture in order to learn about
a production process or other operations
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
? 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.
? Among all factor markets, the labour
market is the least perfect.
? 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.
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 in less
developed nations.
? 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.
? 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
auto dealership.
? 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.
Q
u
a
n
t
i
t
y
Q
u
a
n
t
i
t
y
The U.S.
Less
advanced
countries
production
New product Maturing product Standardized
product
New product Maturing product Standardized
product
export
s
import
s
production
import
s
export
s
? 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.
? 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.
? Several developed nations are the sources of
FDI outflows.
? About 90% of total world-wide FDI comes from the
developed world.
? Both developing and developed nations are
the recipient of inflows of FDI.
0
20
40
60
80
100
120
A
u
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i
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e
d
K
i
n
g
d
o
m
U
n
i
t
e
d
S
t
a
t
e
s
Inflows
Outflows
? The key to international diversification is to
select foreign projects whose performance
levels are not highly correlated over time.
Merrimack Co. is a U.S. firm that is considering
the location of a new investment project.
Characteristics of Proposed
Project If Located in
the U.S. the U.K.
Project’s mean expected
annual after-tax return
Standard deviation of
project’s return
Correlation of project’s
return with return on
existing U.S. business
25%
.09
.80
25%
.11
.02
? 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 located in the U.S.
? Suppose that the project constitutes 30% of
Merrimack’s total funds, and that the
standard deviation of Merrimack’s return on
existing U.S. business is .10.
? If the new project is located in the U.S., the
portfolio variance for the overall firm
( )( )( )( )( )
008653 .
80 . 09 . 10 . 30 . 70 . 2 09 . 30 . 10 . 70 .
? ? 2
2 2 2 2
2 2 2 2
=
+ + =
+ + =
AB B A B A B B A A
CORR w w w w ? ?
? If the new project is located in the U.K., the
portfolio variance for the overall firm
• Thus, as a whole, Merrimack will generate
more stable returns if the new project is
located in the U.K.
( )( )( )( )( )
0060814 .
02 . 11 . 10 . 30 . 70 . 2 11 . 30 . 10 . 70 .
2
2 2 2 2
2 2 2 2
=
+ + =
+ + =
AB B A B A B B A A
CORR w w w w ? ? ? ?
? An MNC may not be insulated from a global
crisis, since many countries will be adversely
affected.
? However, as can be seen from the 1997-98
Asian crisis, an MNC that had diversified
among the Asian countries might have fared
better than if it had focused on one country.
Even better would be diversification among
the continents.
-15
-10
-5
0
5
10
15
1990 1992 1994 1996 1998 2000
China Hong Kong Indonesia Japan
Korea Malaysia Philippines Singapore
Taiwan Thailand
A
n
n
u
a
l
%
A
i
n
G
D
P
(
c
o
n
s
t
a
n
t
p
r
i
c
e
s
)
For Selected Asian Economies
-8
-4
0
4
8
1990 1992 1994 1996 1998 2000
Australia Brazil Canada Germany
Mexico South Africa U.K. U.S.
A
n
n
u
a
l
%
A
i
n
G
D
P
(
c
o
n
s
t
a
n
t
p
r
i
c
e
s
)
For Selected Non-Asian Economies
? As more projects are added to a portfolio, the
portfolio variance should decrease on
average, up to a certain point.
? However, the degree of risk reduction is
greater for a global portfolio than for a
domestic portfolio, due to the lower
correlations among the returns of projects
implemented in different economies.
Domestic
Project Portfolio
Global
Project Portfolio A
v
e
r
a
g
e
V
a
r
i
a
n
c
e
o
f
R
e
t
u
r
n
s
Number of Projects
? An MNC with projects positioned around
the world is concerned about the risk and
return characteristics of its projects.
Frontier
of efficient
project portfolios
E
x
p
e
c
t
e
d
R
e
t
u
r
n
Risk
? Project portfolios along the efficient frontier
exhibit minimum risk for a given expected
return.
? Of these efficient portfolios, an MNC may
choose one that corresponds to its
willingness to accept risk.
? The frontiers of efficient project portfolios of
some MNCs are more desirable than the
frontiers of other MNCs.
Efficient frontier for
a single-product MNC
Efficient frontier for
a multi-product MNC
E
x
p
e
c
t
e
d
R
e
t
u
r
n
Risk
? Some periodic decisions are necessary.
? Should further expansion take place?
? Should the earnings be remitted to the parent, or
used by the subsidiary?
Incentives to Encourage DFI
Reduces unemployment and lack on technology without
taking business from local firms
Govt uses incentives like tax breaks, rent free land and
building, low interest loans, subsidized energy and
reduced environmental regulations
Barriers to DFI
? Barriers that protect local firms or consumers
? Barriers that restrict ownership
? Red tape barriers
? Industry barriers
? Political Instability
? 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 judgment about the
appropriateness of the foreign government’s
existing legislation.
? A big source of risk is the non-enforcement
of contracts.
? 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.
? Transfer Risk
? Uncertainty regarding cross-border flows of
capital.
? Operational Risk
? Uncertainty regarding host countries policies on
firm’s operations.
? Control Risk
? Uncertainty regarding expropriation.
? Geographic diversification
? Simply put, don’t put all of your eggs in one
basket.
? Minimize exposure
? Form joint ventures with local companies.
? Local government may be less inclined to expropriate
assets from 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.
? Insurance
? The Overseas Private Investment Corporation (OPIC) a
U.S. government federally owned organization, offers
insurance against:
1. The inconvertibility of foreign currencies.
2. Expropriation of U.S.-owned assets.
3. Destruction of U.S.-owned physical properties due to
war, revolution, and other violent political events in
foreign countries.
4. Loss of business income due to political violence
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
DFI Decisions on
Type of Business and Location
doc_168627640.pptx
Describe common motives for initiating direct foreign investment (DFI) and to illustrate the benefits of international diversification.
? To describe common motives for initiating
direct foreign investment (DFI); and
? To illustrate the benefits of international
diversification.
Classification 1 :
• Revenue related Motives
• Cost related Motives
Classification 2 :
• Trade Barriers
• Labor Market Imperfections
• Intangible Assets
• Vertical Integration
• Product Life Cycle
• Shareholder Diversification
Revenue related
Motives
Means of using DFI to achieve this
benefit
Attract new sources of
demand
Establish a subsidiary or acquire a
competitor in a new market
Enter markets where
superior profits are
possible
Acquire a competitor that has controlled it’s
local market
Exploit monopolistic
advantages
Establish a subsidiary in a market where
competitors are unable to produce the
identical product: sell products in that
country
React to trade
restrictions
Establish a subsidiary in a market where
tougher trade restrictions will adversely
affect the firm’s export volume
Diversify internationally
Establish a subsidiaries in a market whose
business cycles differ from those where
existing subsidiaries are based
Cost related
Motives
Means of using DFI to achieve this
benefit
Fully benefit from
economies of
scale
Establish a subsidiary in a new market that can sell
products produced elsewhere; this allows for
increased production and possibly greater
production efficiency
Use foreign
factors of
production
Establish a subsidiary in a market that has
relatively low costs of labor or land; sell the
finished product to countries where cost of
production is higher
Use foreign raw
materials
Establish a subsidiary in a market where raw
materials are cheap and accessible; sell the
finished product to countries where the raw
materials are more expensive
Use foreign
technology
Participate in a joint venture in order to learn about
a production process or other operations
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
? 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.
? Among all factor markets, the labour
market is the least perfect.
? 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.
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 in less
developed nations.
? 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.
? 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
auto dealership.
? 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.
Q
u
a
n
t
i
t
y
Q
u
a
n
t
i
t
y
The U.S.
Less
advanced
countries
production
New product Maturing product Standardized
product
New product Maturing product Standardized
product
export
s
import
s
production
import
s
export
s
? 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.
? 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.
? Several developed nations are the sources of
FDI outflows.
? About 90% of total world-wide FDI comes from the
developed world.
? Both developing and developed nations are
the recipient of inflows of FDI.
0
20
40
60
80
100
120
A
u
s
t
r
a
l
i
a
C
a
n
a
d
a
C
h
i
n
a
F
r
a
n
c
e
G
e
r
m
a
n
y
I
t
a
l
y
J
a
p
a
n
M
e
x
i
c
o
N
e
t
h
e
r
l
a
n
d
s
S
p
a
i
n
S
w
e
d
e
n
S
w
i
t
z
e
r
l
a
n
d
U
n
i
t
e
d
K
i
n
g
d
o
m
U
n
i
t
e
d
S
t
a
t
e
s
Inflows
Outflows
? The key to international diversification is to
select foreign projects whose performance
levels are not highly correlated over time.
Merrimack Co. is a U.S. firm that is considering
the location of a new investment project.
Characteristics of Proposed
Project If Located in
the U.S. the U.K.
Project’s mean expected
annual after-tax return
Standard deviation of
project’s return
Correlation of project’s
return with return on
existing U.S. business
25%
.09
.80
25%
.11
.02
? 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 located in the U.S.
? Suppose that the project constitutes 30% of
Merrimack’s total funds, and that the
standard deviation of Merrimack’s return on
existing U.S. business is .10.
? If the new project is located in the U.S., the
portfolio variance for the overall firm
( )( )( )( )( )
008653 .
80 . 09 . 10 . 30 . 70 . 2 09 . 30 . 10 . 70 .
? ? 2
2 2 2 2
2 2 2 2
=
+ + =
+ + =
AB B A B A B B A A
CORR w w w w ? ?
? If the new project is located in the U.K., the
portfolio variance for the overall firm
• Thus, as a whole, Merrimack will generate
more stable returns if the new project is
located in the U.K.
( )( )( )( )( )
0060814 .
02 . 11 . 10 . 30 . 70 . 2 11 . 30 . 10 . 70 .
2
2 2 2 2
2 2 2 2
=
+ + =
+ + =
AB B A B A B B A A
CORR w w w w ? ? ? ?
? An MNC may not be insulated from a global
crisis, since many countries will be adversely
affected.
? However, as can be seen from the 1997-98
Asian crisis, an MNC that had diversified
among the Asian countries might have fared
better than if it had focused on one country.
Even better would be diversification among
the continents.
-15
-10
-5
0
5
10
15
1990 1992 1994 1996 1998 2000
China Hong Kong Indonesia Japan
Korea Malaysia Philippines Singapore
Taiwan Thailand
A
n
n
u
a
l
%
A
i
n
G
D
P
(
c
o
n
s
t
a
n
t
p
r
i
c
e
s
)
For Selected Asian Economies
-8
-4
0
4
8
1990 1992 1994 1996 1998 2000
Australia Brazil Canada Germany
Mexico South Africa U.K. U.S.
A
n
n
u
a
l
%
A
i
n
G
D
P
(
c
o
n
s
t
a
n
t
p
r
i
c
e
s
)
For Selected Non-Asian Economies
? As more projects are added to a portfolio, the
portfolio variance should decrease on
average, up to a certain point.
? However, the degree of risk reduction is
greater for a global portfolio than for a
domestic portfolio, due to the lower
correlations among the returns of projects
implemented in different economies.
Domestic
Project Portfolio
Global
Project Portfolio A
v
e
r
a
g
e
V
a
r
i
a
n
c
e
o
f
R
e
t
u
r
n
s
Number of Projects
? An MNC with projects positioned around
the world is concerned about the risk and
return characteristics of its projects.
Frontier
of efficient
project portfolios
E
x
p
e
c
t
e
d
R
e
t
u
r
n
Risk
? Project portfolios along the efficient frontier
exhibit minimum risk for a given expected
return.
? Of these efficient portfolios, an MNC may
choose one that corresponds to its
willingness to accept risk.
? The frontiers of efficient project portfolios of
some MNCs are more desirable than the
frontiers of other MNCs.
Efficient frontier for
a single-product MNC
Efficient frontier for
a multi-product MNC
E
x
p
e
c
t
e
d
R
e
t
u
r
n
Risk
? Some periodic decisions are necessary.
? Should further expansion take place?
? Should the earnings be remitted to the parent, or
used by the subsidiary?
Incentives to Encourage DFI
Reduces unemployment and lack on technology without
taking business from local firms
Govt uses incentives like tax breaks, rent free land and
building, low interest loans, subsidized energy and
reduced environmental regulations
Barriers to DFI
? Barriers that protect local firms or consumers
? Barriers that restrict ownership
? Red tape barriers
? Industry barriers
? Political Instability
? 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 judgment about the
appropriateness of the foreign government’s
existing legislation.
? A big source of risk is the non-enforcement
of contracts.
? 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.
? Transfer Risk
? Uncertainty regarding cross-border flows of
capital.
? Operational Risk
? Uncertainty regarding host countries policies on
firm’s operations.
? Control Risk
? Uncertainty regarding expropriation.
? Geographic diversification
? Simply put, don’t put all of your eggs in one
basket.
? Minimize exposure
? Form joint ventures with local companies.
? Local government may be less inclined to expropriate
assets from 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.
? Insurance
? The Overseas Private Investment Corporation (OPIC) a
U.S. government federally owned organization, offers
insurance against:
1. The inconvertibility of foreign currencies.
2. Expropriation of U.S.-owned assets.
3. Destruction of U.S.-owned physical properties due to
war, revolution, and other violent political events in
foreign countries.
4. Loss of business income due to political violence
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
DFI Decisions on
Type of Business and Location
doc_168627640.pptx