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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 contractsafter investment
Contract risk: problems with local
partners
Currency risk
Market risk: costs of energy anddemand 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 forconstruction, power supply contracts,
and technology transfer
More reliance on local partners to
construct and operate project
Greater participation of other Indianinstitutions
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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 Business
FDI is what makes the company a multinational firm
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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: $30,362 billion (2003)
Employment of foreign affiliates: Over54
million people(2003 estimated)
Data from United Nations World Investment Report andUNCTAD website
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FDI
2003$
Billions
FDI inflows FDI outflows
Developedcountries
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 in
control
,
Increase in
commitment
and 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 countrys
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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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 of30% NPV Country X = $8,000
Invest in Country A
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Apply NPV analysis to choose
level of FDI
)1(
)(max
r
KVKtoKChoose
)1(
*)(1
r
solvesInvestment
d!
Therefore, 1 + r = V'(K*)
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Companies invest less in riskier countries
all other things equal
*)(1 KVr d!
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 themanager
choose?
V'(K) = 3.2 .5K.
1 + 0.2 =3
.2 .5K*K* = 4.
K V(K) =
3.2K.25K2K+
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 politicalsupport 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 costsavings
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 servicesAbout 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 ofintellectual 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 compositionof FDI undergoing transformation from vertical tohorizontal
FDI offers advantages in terms of ownership and control andavoiding trade barriers
Choose target countries based on expected cash flow andcosts of investment and discount using risk adjusted rate of
return
Adjust level of investment to reflect expected cash flow andrisk-adjusted rate of return
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