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Part IVLong-Term Asset and Liability Management

ExistingHost Country

Tax Laws

ExchangeRate

Projections

Country RiskAnalysis

Risk Unique toMultinational

Project

MNCs Costof Capital

InternationalInterest Rateson Long-Term

Funds

MNCs Access

to Foreign

Financing

PotentialRevision in

Host Country

Tax Laws orOtherProvisions

EstimatedCash Flows ofMultinational

Project

RequiredReturn on

MultinationalProject

MultinationalCapital

BudgetingDecisions

Internat ional Financial Management, 2ndedi t ion, Jeff Madura and Roland Fox

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Cost and Management Accounting: A n Introduction, 7thedit ion

Colin DruryISBN 978-1-40803-213-9 2011 Cengage Learning EMEA

Chapter 13

Direct Foreign Investment

Internation al Financial Managemen t, 2ndedit ion

Jeff Madura and Roland FoxISBN 978-1-4080-3229-9 2011 Cengage Learning EMEA


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Chapter Objectives

To describe common motives for

initiating direct foreign investment

(DFI).

To illustrate the benefits of

international diversification.




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Motives for DFI

MNCs commonly consider DFI because it

can improve their profitability and enhance

shareholder wealth.

In most cases, MNCs engage in DFI

because they are interested in boosting

revenues, reducing costs, or both.




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Revenue-Related Motives for

DFI

3. Exploit

monopolistic

advantages

Establish a subsidiary in a market

where competitors are unable to

produce the identical product.

5. Diversify

internationally

Establish subsidiaries in markets

with different business cycles.

1. Attract new sources

of demand

Establish a subsidiary or acquire

a competitor in a new market.

Motives Means of Achieving Benefit

2. Enter profitable

markets

Acquire a competitor that has

controlled its local market.

4. React to traderestrictions

Establish a subsidiary in a marketwhere trade restrictions will

adversely affect export volume.




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Cost-Related Motives for DFI

3. Use foreign raw

materials


where raw materials are cheap

and accessible. Sell the products

in that market and elsewhere.

1. Fully benefit from

economies of scale

Establish a subsidiary in a new

market where products produced

elsewhere can be sold. This

allows for increased production

and greater production efficiency.


2. Use foreign factors

of production


that has lower costs of labor or

land. Sell the products elsewhere.

Internat ional Financial Management, 2ndedi t ionJeff Madura and Roland Fox

ISBN 978-1-4080-3229-9 2011 Cengage Learning EMEA


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Cost-Related Motives for DFI

4. Use foreign

technology

Participate in a joint venture or

acquire an existing overseas

plant to learn about foreign

production processes, so as to

improve its own operations.


5. 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.

Internation al Financial Management, 2ndedit ion



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Motives for DFI

The European Unions recent expansion

enables members to transport products

throughout Europe at reduced tariffs.

New low-wage members (such as Poland,

the Czech Republic and Romania) were

thus targeted for new DFI by MNCs that

wanted to reduce manufacturing costs. However, there is a tradeoffthousands of

jobs were lost in Western Europe.




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General Motors (Vauxhall and Opel) expanded its

production in Poland, Peugeot increased its

production in the Czech Republic, Toyota

expanded its production in Slovakia, Audi

expanded in Hungary, and Renault expanded in

Romania. Volkswagen recently expanded its

capacity in Slovenia, and cut some jobs in Spain.While it originally established operations in Spain

because the wages were about half of those in

Germany, wages in Slovenia are less than half of

those in Spain.




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Comparing the Benefits of DFIAcross Countries (1)

The optimal method for a firm to penetrate

a foreign market is partially dependent on

the characteristics of the market.

For example, if the consumers are used to

buying products from local firms, then

licensing arrangements or joint ventures

may be more appropriate.




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Comparing the Benefits of DFIAcross Countries (2)

Before investing in a foreign country, the

potential benefits must be weighed against

the costs and risks associated with that

specific country.

In particular, the MNC will want to review

the foreign countrys economic growth and

other macroeconomic indicators, as wellas the political structure and policy issues.




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Comparing the Benefits of DFI

Over Time As conditions change over time, somecountries may become more attractive

targets for DFI, while other countries

become less attractive.

Europe (especially Eastern Europe), Latin

America, and Asia now receive a larger

proportion of DFI than in the past.




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Benefits of International

Diversification The key to international diversification is toselect foreign projects whose performance

levels are not highly correlated over time. In this way, the various international

projects are less likely to experience poor

performance simultaneously.




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Diversification Benefits forMerriweather Co. (1)

Merriweather Co., a U.K. firm, plans to invest ina new project in either the U.S. or the U.K.

Characteristics of Proposed Project

If Located in the

U.K.

If Located in the

U.S.Mean expected annual return

on investment (after taxes)

25% (0.25) 25% (0.25)

Standard deviation of expected

annual after-tax returns oninvestment

.09 0.11

Correlation of expected annual

after-tax returns on investment

with after-tax returns of

prevailing U.S. business

0.80 0.02

Internat ional Financial Management, 2ndedi t ion, Jeff Madura and Roland Fox

- - - -


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Diversification Benefits for

Merriweather Co. (2) In terms of return, neither new project

has an advantage.

With regard to risk, the new project isexpected to exhibit slightly less variability

in returns if it is located in the U.K.

However, estimating the risk of theindividual project without considering the

overall firm would be a mistake.




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Merriweather Co. (3) Suppose that the project will constitute 30% of

Merriweathers total funds invested in itself, and that

the standard deviation of return on its existing

business is .10. If the new project is located in the U.K., the portfolio

variance for the overall firm

008653.

80.09.10.30.70.209.30.10.70.

22222

2222

ABBABABBAA CORRwwww




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Merriweather Co. (4) If the new project is located in the U.K., the

portfolio variance for the overall firm

Thus, as a whole, Merriweather will generatemore stable returns if the new project is

located in the U.K.

0060814.

02.11.10.30.70.211.30.10.70.

2

2222

2222

ABBABABBAA CORRwwww




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Diversification Analysis of

International Projects (1) Like any investor, an MNC with

projects positioned around the world is

concerned with the risk and return

characteristics of the projects.

The portfolio of all projects reflects theMNC in aggregate.




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ExpectedReturn

Risk

Risk-Return Analysis ofInternational Projects

When the projects are combined appropriately, the project

portfolio may be able to achieve a risk-return tradeoff

exhibited by any of the points on the frontier of efficient

project portfolios.

Frontier of efficientproject portfolios A

B

C

G

D

E F

Project A hasthe highestexpectedreturn andgreatest risk.




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International Projects (2) Project portfolios along the efficient frontier

exhibit minimum risk for a given expected

return.

Of these efficient project portfolios, an MNC

may choose one that corresponds to its

willingness to accept risk.

The actual location of the frontier of efficientproject portfolios depends on the business

in which the firm is involved.




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Expected

Return

Risk


International Projects (3) Some MNCs have frontiers of possible projectportfolios that are more desirable than the frontiers

of other MNCs.

Efficient frontierfor a single-product MNC

Efficient frontier fora multiproductMNC




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International Projects (4) Our discussion suggests that MNCs can

achieve more desirable risk-return

characteristics from their project portfoliosif they sufficiently diversify among

products and geographic markets.



C i f E i G th A C t i


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Comparison of Economic Growth Among Countries


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Decisions Subsequent

to DFI Some periodic decisions are necessary: Should further expansion take place?

Should the earnings be remitted to theparent, or used by the subsidiary?

These decisions should be analyzed on a

case-by-case basis.




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Host Government View of DFI

Each government must weigh the

advantages and disadvantages of DFI

in its country.

The government may provide

incentives to encourage desirable

forms of DFI, and impose preventive

barriers or conditions on other forms

of DFI.




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Incentives to Encourage DFI

The ideal DFI solves problems such as

unemployment and lack of technology

without taking business away from the local

firms.

Common incentives offered by host

governments include tax breaks, discounted

rent for land and buildings, low-interestloans, subsidized energy, and reduced

environmental restrictions.




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Barriers to DFI

Governments are less anxious to

encourage DFI that adversely affects local

firms, consumers and the economy.

DFI barriers include regulations governingmergers and acquisitions, restrictions on

foreign ownership of local firms, red tape

(procedural and documentation

requirements), the political influence of local

firms, and political instability.




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Colin DruryISBN 978 1 40803 213 9 2011 Cengage Learning EMEA

Government-ImposedConditions to Engage in DFI

Some governments allow international

acquisitions but impose special

requirements on the MNCs that desire to

acquire a local firm.

Such conditions include environmental

constraints, restrictions on local sales, and

employment requirements.


Jeff Madura and Roland FoxISBN 978 1 4080 3229 9 2011 Cengage Learning EMEA

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