Post on 24-Dec-2015
Competitive Strategies: Modes of Entry and FDI
© Professor Daniel F. Spulber
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Enron India
What risks did Enron face going into the Dabhol project?
• Political risk: expropriation of investment
• Political risk: renegotiation of contracts after investment
• Contract risk: problems with local partners
• Currency risk
• Market risk: costs of energy and demand for electric power
• Recovery of investment costs (FDI)
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Enron India
How did Enron prepare for the risks of the project?
• Long term contracts: purchase agreement, Maharashtra State Electrical Board was a credible buyer
• Political risk: participation of Overseas Private Investment Corp, US Export-Import Bank, International Finance Corp.
• Revenues tied to US dollar
• Partners GE and Bechtel
• Substantial research
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Enron India
How could Enron have dealt with risk more effectively?
• Enron could have relied less on FDI
• Enron could have emphasized transactions, making arrangements for construction, power supply contracts, and technology transfer
• More reliance on local partners to construct and operate project
• Greater participation of other Indian institutions
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Enron India
Why did Enron choose ownership (FDI)?
• To exercise control over assets in investment projects
• To control technology due to limits on intellectual property rights
• To improve operational effectiveness
• To learn about market for future projects
• To avoid expected contract risk
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Enron International Operations
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Financial Highlights: Growth in assets
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FDI is a key aspect of International BusinessFDI is what makes the company a multinational firm
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FDI
FDI includes cross-border business investment and M&A.
(not portfolio investment)
World FDI inflows:
$209 billion (1990) (Cross-border M&A: $151 b.)
$1,492 billion (2000) (Cross-border M&A: $1,144 b.)
$735 billion (2001) (Cross-border M&A: $594 b.)
$651 billion (2002) (Cross-border M&A $ 370 b.)
$560 billion (2003) (Cross-border M&A $ 297 b.)
Compare with world total gross fixed capital formation: $7,294 b.
(2003)
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FDI
• World FDI inward stock: $8,245 billion (2003)
• Sales of foreign affiliates: $17,580 billion (2003)(Compare with international trade of $9,228 billion (2003)
• Gross product of foreign affiliates: $3,706 billion (2003)(Compare with world GDP of $36 trillion in 2003).
• Total assets of foreign affiliates: $30,362 billion (2003)
• Employment of foreign affiliates: Over 54 million people (2003 estimated)
Data from United Nations World Investment Report and UNCTAD website
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FDI
2003 $ Billions
FDI inflows FDI outflows
Developed countries
367 570
Developing countries
172 36
Central and Eastern Europe
21 7
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International modes of entry and value at risk
• FDI – whether M&A or company growth – puts full value at risk.
Toyota factory, Wal-Mart store
• Managers of an international business choose the mode of entry based on a trade-off between risk versus control in the particular supplier or customer country
• Joint ventures, not only share knowledge, but also share investment costs and value at risk
• Spot or contract sales can substantially reduce value at risk
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International modes of entry and value at risk
• M&A• Growth• Alliances
/ Joint Ventures
• Licenses• Contract• Spot
Increase incontrol,
Increase incommitm
entand risk
• Choice of entry mode jointly determines degree of control and extent of risk
• Degree of commitment depends on contractual duration and vertical integration
• With less knowledge of other country’s market, choose lower degree of commitment
• As knowledge increases over time, can increase degree of commitment to get closer to desired entry mode.
• Contractual transactions may give optimal mix of control and commitment
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Choosing target countries for FDI
• Costs of investment project K
• Estimate potential expected returns V(K)
• Determine risks associated with revenues and costs in host country -- Best estimates of expected cash flow
• Apply appropriate risk-adjusted discount rate r
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Choosing target countries for FDI
Country A
Country X
NPV = - K + VA/(1 + rA)
NPV = - K + VX/(1 + rX)
Manager considers trade off between risk and return
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Apply NPV analysis to choose target country for FDI
Example: Investment cost is K = $2,000
Investment in Country A yields an expected net cash flow of $12,600 with risk-adjusted discount rate of 20% NPV Country A = $8,500
Investment in Country X yields an expected net cash flow of $13,000 with risk-adjusted discount rate of 30% NPV Country X = $8,000
Invest in Country A
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Apply NPV analysis to chooselevel of FDI
)1(
)(max
r
KVKtoKChoose
)1(
*)(1
r
KVsolvesKInvestment
Therefore, 1 + r = V'(K*)
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Companies invest less in riskier countriesall other things equal
*)(1 KVr
1 + 0.2
1 + 0.3
KK* K*
$/K
V’(K)
Expected marginal return to FDI equals 1 + r.Note diminishing marginal return to investment
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FDI Example: Choosing the level of investment
Let r = 0.2
What level of investment should the manager choose?
V'(K) = 3.2 – .5K.
1 + 0.2 = 3.2 –.5K*
K* = 4.
K V(K) = 3.2K –.25K2
–K + V(K)/(1 + 0.2)
1 2.95 1.458
2 5.40 2.5
3 7.35 3.125
4 8.80 3.333 ***
5 9.75 3.125
6 10.20 2.5
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Why is FDI so common in international business? Advantages of FDI
• Production or distribution facilities in a country can reduce costs of trade (transportation, tariff and nontariff barriers, transaction costs, and time) – Toyota in US
• Production within a country takes advantage of domestic sourcing of parts, components, services
• Investment and employment in host country gain political support for the international business:
“quid pro quo investment” – Cemex and Southdown
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Why is FDI so common in international business? Advantages of FDI
• Closer to customers for manufacturers
• Necessary for retail and wholesale companies – Wal Mart, Carrefour, Ingram Micro
• Take advantage of low-cost labor, highly-skilled labor, and proximity to resources
• Reduce costs of trade from import/export
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Advantages of vertical FDI
• Coordination advantages through the value chain
• Access to production facilities, sourcing networks and distribution networks
• Keeping technology and intellectual property in-house
• Substitution of internal transactions for market transactions
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Advantages of Horizontal FDI
• M&A acquisition of competitors for market power or cost savings
• M&A to achieve economies of scale and scope (Daimler/Chrysler, VW)
• M&A to purchase of technology
• M&A to acquire brand names
• Production avoids costs of trade relative to export
• As hedge against demand and supply fluctuations -- Cemex
• Market power in international purchasing (e.g. Vodaphone/Airtouch purchases wireless equipment for its many operations)
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Disadvantages of FDI
• Risk that firm many not recover investment and returns to investment in supplier country
• FDI increases capital investment, reduces flexibility
• FDI ties business to particular country locations for production or distribution
• Vertical FDI makes the firm more vertically integrated
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FDI Trends
• Shift of investment mix toward services About half in 1990, about two thirds in 2000
• Shift of investment to outsourcing abroad (offshoring + outsourcing) – reduction in vertical integration
• Globalization (lower costs of trade) leading to reduction in vertical FDI
• Globalization (market integration) likely to lead to increases in horizontal FDI
UNCTAD World Investment Report 2004
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Licensing versus FDI
Why is FDI more prevalent than technology licensing?
• Licensing agreements depend heavily on international enforcement of intellectual property rights
• International licensing also entails costs of trade
• International licensing is quite common amongst developed countries, reaching levels up to 1/3 of domestic R&D expenditures
• International licensing experiencing rapid growth
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Overview and Take-Away Points
• FDI a major feature of international business – composition of FDI undergoing transformation – from vertical to horizontal
• FDI offers advantages in terms of ownership and control and avoiding trade barriers
• Choose target countries based on expected cash flow and costs of investment and discount using risk adjusted rate of return
• Adjust level of investment to reflect expected cash flow and risk-adjusted rate of return