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