Part IV Long-Term Asset and Liability Management Existing Host Country Tax 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 Tax 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 ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Chapter 13 Direct Foreign Investment International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Chapter Objectives To describe common motives for initiating direct foreign investment (DFI). To illustrate the benefits of international diversification. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

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. MotivesMeans of Achieving Benefit 2.Enter profitable markets Acquire a competitor that has controlled its local market. 4.React to trade restrictions Establish a subsidiary in a market where trade restrictions will adversely affect export volume. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

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. MotivesMeans 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

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. MotivesMeans 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Motives for DFI The European Union’s 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 tradeoff—thousands of jobs were lost in Western Europe. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Comparing the Benefits of DFI Across 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Comparing the Benefits of DFI Across 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 country’s economic growth and other macroeconomic indicators, as well as the political structure and policy issues. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Comparing the Benefits of DFI Over Time As conditions change over time, some countries 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Benefits of International Diversification The key to international diversification is to select 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Diversification Benefits for Merriweather Co. (1) Merriweather Co., a U.K. firm, plans to invest in a 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) Standard deviation of expected annual after-tax returns on investment Correlation of expected annual after-tax returns on investment with after-tax returns of prevailing U.S. business International Financial Management, 2 nd edition, Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Diversification Benefits for Merriweather Co. (2) In terms of return, neither new project has an advantage. With regard to risk, the new project is expected to exhibit slightly less variability in returns if it is located in the U.K. However, estimating the risk of the individual project without considering the overall firm would be a mistake. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Diversification Benefits for Merriweather Co. (3) Suppose that the project will constitute 30% of Merriweather’s 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 International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 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 generate more stable returns if the new project is located in the U.K. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 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 the MNC in aggregate. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Expected Return Risk Risk-Return Analysis of International 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 efficient project portfolios A B C G D E F Project A has the highest expected return and greatest risk. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 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 efficient project portfolios depends on the business in which the firm is involved. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Expected Return Risk Diversification Analysis of International Projects (3) Some MNCs have frontiers of possible project portfolios that are more desirable than the frontiers of other MNCs. Efficient frontier for a single- product MNC Efficient frontier for a multiproduct MNC International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Diversification Analysis of International Projects (4) Our discussion suggests that MNCs can achieve more desirable risk-return characteristics from their project portfolios if they sufficiently diversify among products and geographic markets. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Comparison of Economic Growth Among Countries

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Decisions Subsequent to DFI Some periodic decisions are necessary: –Should further expansion take place? –Should the earnings be remitted to the parent, or used by the subsidiary? These decisions should be analyzed on a case-by-case basis. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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-interest loans, subsidized energy, and reduced environmental restrictions. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Barriers to DFI Governments are less anxious to encourage DFI that adversely affects local firms, consumers and the economy. DFI barriers include regulations governing mergers and acquisitions, restrictions on foreign ownership of local firms, red tape (procedural and documentation requirements), the political influence of local firms, and political instability. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Government-Imposed Conditions 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA