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Part IV Long-Term Asset and Liability Management Existing Host Country T ax Laws Exchange Rate Projections Country Risk Analysis Risk Unique to Multinational Project MNC’s Cost of Capital International Interest Rates on Long-Term Funds MNC’s Access to Foreign Financing Potential Revision in Host Country T ax Laws or Other Provisions Estimated Cash Flows of Multinational Project Required Return on Multinational Project Multinational Capital Budgeting Decisions International Financial Management, 2  nd  edition, Jeff Madura and Roland Fox -- - -

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chapter 14

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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

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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

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

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

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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

    Establish a subsidiary in a market

    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.

    Motives Means of Achieving Benefit

    2. Use foreign factors

    of production

    Establish a subsidiary in a market

    that has lower costs of labor or

    land. Sell the products elsewhere.

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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.

    Motives Means of Achieving Benefit

    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.

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

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

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

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

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

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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

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

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

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    Diversification Benefits for

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

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

    Diversification Benefits for

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

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

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

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

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    Diversification Analysis of

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

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    Expected

    Return

    Risk

    Diversification Analysis of

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

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    Diversification Analysis of

    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.

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

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

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

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

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

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    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.

    Internation al Financial Managemen t, 2ndedit ion

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