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