INTERNATIONAL FINANCE Lecture 29

Review Economic Exposure through empirical analysis with Significant slope coefficients Possible hedging ¤ Restructuring ¤ Fixed Assets Translation Exposure Hedging Source: Adopted from South-Western/ Thomson Learning 2006

DIRECT FOREIGN INVESTMENT Lecture 29

Objectives To describe common motives for initiating direct foreign investment (DFI); To illustrate the benefits of international diversification.

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.

Revenue-Related Motives for DFI  Exploit monopolistic advantages. Establish a subsidiary in a market where competitors are unable to produce the identical product.  Diversify internationally. Establish subsidiaries in markets with different business cycles.  Attract new sources of demand. Establish a subsidiary or acquire a competitor in a new market. MotivesMeans of Achieving Benefit  Enter profitable markets. Acquire a competitor that has controlled its local market.  React to trade restrictions. Establish a subsidiary in a market where trade restrictions will adversely affect export volume.

Cost-Related Motives for DFI  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.  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  Use foreign factors of production. Establish a subsidiary in a market that has lower costs of labor or land. Sell the products elsewhere.

Cost-Related Motives for DFI  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  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.

Review common motives for initiating direct foreign investment Revenues ¤ Attract new sources of demand ¤ Enter profitable markets ¤ Exploit monopolistic advantages. ¤ Diversify internationally Costs ¤ Fully benefit from economies of scale ¤ Use foreign factors of production ¤ Use foreign raw materials ¤ Use foreign technology ¤ React to exchange rate movements Source: Adopted from South-Western/ Thomson Learning 2006

A corporation often reaches a stage when growth is limited in its home country, possibly because of intense competition. Even if it faces little competition, its market share in its home country may already be near its potential peak. Thus, the firm may consider foreign markets where there is potential demand. Many developing countries, such as Argentina, Chile, Mexico, Hungary, and China, have been perceived as attractive sources of new demand. Motives

Motives Many MNCs have penetrated these countries since barriers have been removed. Because the consumers in some countries have historically been restricted from purchasing goods produced by firms outside their countries, the markets for some goods are not well established and offer much potential for penetration by MNCs.

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. Motives

Enter profitable markets. If other corporations in the industry have proved that superior earnings can be realized in other markets, an MNC may also decide to sell in those markets. It may plan to undercut the prevailing, excessively high prices. A common problem with this strategy is that previously established sellers in a new market may prevent a new competitor from taking away their business by lowering their prices just when the new competitor attempts to break into this market. Motives

Exploit monopolistic advantages. Firms may become internationalized if they possess resources or skills not available to competing firms. If a firm possesses advanced technology and has exploited this advantage successfully in local markets The firm may attempt to exploit it internationally as well. In fact, the firm may have a more distinct advantage in markets that have less advanced technology. Motives

Motives Example: Japanese automobile manufacturers established plants in the United States in anticipation that their exports to the United States would be subject to more strict trade restrictions. Japanese companies recognized that trade barriers could be established that would limit or prohibit their exports. By producing automobiles in the United States, Japanese manufacturers could avoid trade barriers.

Comparing the Benefits of DFI Across Countries 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.

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. Comparing the Benefits of DFI Across Countries

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.

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.

Example Several firms experienced weak sales because of reduced U.S. demand for their products. They responded by increasing their expansion in foreign markets. AT&T and Nortel Networks pursued new business in China. U.S. Technology planned substantial expansion in Europe and Asia. IBM increased its presence in China, India, South Korea, and Taiwan. Cisco

Example Systems expanded substantially in China, Japan, and South Korea. Foreign expansion diversifies an MNC’s sources of revenue and thus reduces its reliance on the U.S. economy. Wal-Mart has not only diversified internationally but has spread its business into many emerging markets as well. Thus, it is less sensitive to a recession in the more developed countries such as those in Western Europe.

Merrimack Co., a U.S. firm, plans to invest in a new project in either the U.S. or the U.K. Characteristics of Proposed Project If Located in in the U.S. in the U.K. Project’s mean expected annual after-tax return Standard deviation of project’s return Correlation of project’s return with return on existing U.S. business 25% % Diversification Benefits for Merrimack Co.

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.S. However, estimating the risk of the individual project without considering the overall firm would be a mistake. Diversification Benefits for Merrimack Co.

Suppose that the project will constitute 30% of Merrimack’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.S., the portfolio variance for the overall firm Diversification Benefits for Merrimack Co.

If the new project is located in the U.K., the portfolio variance for the overall firm Diversification Benefits for Merrimack Co. Thus, as a whole, Merrimack will generate more stable returns if the new project is located in the U.K.

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. Diversification Analysis of International Projects

Expected Return Risk 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. Risk-Return Analysis of International Projects Frontier of efficient project portfolios A B C G D E F Project A has the highest expected return and greatest risk.

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. Diversification Analysis of International Projects

Expected Return Risk 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 Diversification Analysis of International Projects

The MNCs can achieve more desirable risk- return characteristics from their project portfolios if they sufficiently diversify among products and geographic markets. Diversification Analysis of International Projects

Comparison of Economic Growth Among Countries

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.

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.

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.

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.

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.

Review Source: Adopted from South-Western/ Thomson Learning 2006