Foreign Direct Investment

Chapter 5: Foreign Direct Investment Introduction: Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a product in a foreign country. Once a firm undertakes FDI, it becomes a multinational enterprise. FDI takes on two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. FDI can take the form of greenfield investment or an acquisition of or a merger with an existing local firm. The majority of cross-boarder investment is in the form

The Form of FDI of mergers and acquisitions rather than greenfield investment. Approximately 78% FDI inflows are in the form of mergers and acquisitions. Rationales for mergers and acquisitions are (i) quicker to execute than greenfield investment, (ii) foreign firms are acquired because those firms have valuable strategic assets such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems and the like, (iii) firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology or management skills.

Theories of FDI One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing are open to it. Another set of theories seeks to explain why firms in the same industry often undertake FDI at the same time and why they favor certain locations over others as targets for FDI and a third theory attempts to combine the two as the electric paradigm.

Why FDI/Advantages of FDI The viability of an exporting strategy is often constrained by transportation costs and trade barriers. By limiting import quotas, government increase attractiveness of FDI. Licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor.

Why FDI/Advantages of FDI 4. Licensing does not give a firm the tight control over manufacturing, marketing and strategy in a foreign country that may be required to maximize its profitability. 5. Firm’s skills and know-how are not amenable to licensing.

Benefits and Costs of FDI Host country benefits: Resource transfer effects (+) Employment effects (+) Balance of payments effects (+) Competition and economic growth effects (+)

Benefits and Costs of FDI (B) Host country costs: Adverse effects on competition within the host nation (greater economic power than indigenous competitors) Adverse effects on the balance of payments (subsequent outflow against initial inflow of FDI and substantial import of inputs from abroad) Perceived loss of national sovereignty and autonomy (foreign parent may interfere in key decisions of host country)

Benefits and Costs of FDI (C) Home country benefits: The home country’s balance of payments benefits from the inward flow of foreign earnings. Positive employment effects arise when the foreign subsidiary creates demand for home country export. Benefits arise when the home country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country.

Benefits and Costs of FDI (D) Home country costs: The balance of payments suffers from the initial capital outflow required to finance the FDI. The current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. The current account of balance of payments suffers if the FDI is a substitute for direct exports.

Motives for FDI Attract new source s of demand by establishing a subsidiary. Enter markets in which superior profits are possible. Fully benefit from economies of scale. Use foreign factors of production. Use foreign raw materials.

Motives for FDI 6. Use foreign technology. 7. Exploit monopolistic advantages. 8. React to exchange rate movements. 9. React to trade restrictions. 10. Diversify internationally.

Problem # 1 Expected rate of return from investment in home country is 15% with 4.5% level of risk and from foreign country is 18% with 3.5% level of risk. Fund allocated in home country is 45% and rest in foreign country. Correlation coefficient between returns of two countries is 0.75. What is the portfolio return and risk for the MNC?

Problem # 2 Citi N.A. operates its banking services in Bangladesh, Pakistan and England. It will be in operation for next 3 years in these countries. The cost of capital of Citi N.A. is 10.50%, Calculate the value of the MNC based on the expected annual earnings and expected exchange rate for the next 3 years are given in the following table (amount in million):

Problem #2 Country Year 1 Year 2 Year 3 E(CF) E(ER) BD Pakistan Tk.200 $1=58.50 Tk.250 $1=59.50 Tk.195 $1=59.75 Pakistan Rs.350 $1=50.00 Rs.450 $1=51.50 Rs.500 $1=52.25 England ₤ 215 $1=0.68 ₤ 220 $1=0.69 ₤ 240 $1=0.65

Problem # 3 An US MNC has already invested its 65% fund in home country for earning 14% rate of return with 5% level of risk. Remaining 35% fund can be invested either in US or in UK. If investment is made in US then possible rates of return are 16% with 25% probability, 19% with 55% probability and 12% with 20%v probability. If investment is made in UK then possible rates of return are 10% with 45% probability, 18% with 15% probability and 22% with 40%v probability. The correlation coefficient between rates of return between investments in US is 0.65 and between US & UK is 0.75. In which country, should new investment be made?