1. Chapter-7
Foreign Direct
Investment
Theory & Strategy

2. Overview Present motives for initiating direct foreign investment
Illustrate the benefits of international diversification
Foreign Direct Investment prospects and Problems in Bangladesh

3. Definition of FDI
FDI stands for Foreign Direct Investment, a component of country’s national financial accounts. It is an investment of foreign assets into domestic structures, equipment, business and organizations. Foreign Direct investment is defined as an investment, involving a long-term relationship and reflecting a lasting and control by a resident entity in one economy (foreign direct investor or parent enterprise), in an enterprise resident in one economy other than that of the foreign direct investor enterprise or affiliate enterprise or foreign affiliate. It is also defined as equity held by investors who hold managerial authority in business operations in other countries. FDI refers to investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.

4. Components of FDI
Equity capital: It is the FD investor’s purchase of shares of an enterprise in a country other than its own.
Reinvestment Earnings: It comprise the direct investors’ share of earnings not distributed as dividends by affiliates, or earnings not remitted to the direct investor. Such retained profits by affiliates are reinvested.
Intra-Company Loans: It refers to short or long-term borrowing and lending of funds between direct investors and affiliated enterprise.

5. Benefits of Direct Foreign Investment
Attract new sources of demand
Enter markets in which superior profits are possible
Fully benefit from economies of scale
Use foreign factors of production
Use foreign raw materials
Use foreign technology
Exploit monopolistic advantages
React to exchange rate movements
React to trade restrictions
Diversity internationally

6. Disadvantages of Direct Foreign Investment
Dependent Upon The Market
Expense Of Establishing Subsidiaries
Uncertainty Of Inflation And Exchange Rate Movement
Political Risk

7. FDI
Theory &
Strategy

8. Theory of Comparative Advantage
The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference.

9. Features of Theory of Comparative Advantage
Exporters in Country A sell goods or services to unrelated importers in Country B
Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology
Firms in Country B do likewise, given the factors of production found in Country B
In this way the total combined output of A and B is maximized

10. Features of Theory of Comparative Advantage….
Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade
The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded
Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries
Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally

11. Example of Comparative Advantage
Assume the following…..
Production unit is a mix of land, labor, capital and technology
Examples continues to Exhibit 15.1, 15.2, 15.3 and 15.4 in the Text book
Production capacity
Containers of Sports Shoes
Containers of Stereo Equipments
Thailand has 1000 production units
12 ctrs/unit
6 ctrs/unit
Brazil has 1000 production units
10 ctrs/unit
2 ctrs/unit

12. Limitations of Comparative Advantage
Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:
Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations)
At least two factors of production – capital and technology – now flow directly and easily between countries
Modern factors of production are more numerous than in this simple model

13. Limitations of Comparative Advantage
Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory
Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities
The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale

14. Limitations of Comparative Advantage….
Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNCs and domestic firms.
The comparative advantage of the 21st century, however, is one based more on services, and their cross-border facilitation by telecommunications and the Internet.
The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.

15. Supply Chain Outsourcing
Many locations for supply chain outsourcing exist today (see the following exhibit).
It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.
Clearly, the extent of global outsourcing is reaching out to every corner of the globe.

16. Market Imperfections: A Rationale for the Existence of the Multinational Firm
MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.
Imperfections in the market for products translate into market opportunities for MNEs.
Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.

17. Why do Firms Become Multinational?
Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories:
Market seekers
Raw material seekers
Production efficiency seekers
Knowledge seekers
Political safety seekers
These categories are not mutually exclusive.

18. Sustaining and Transferring Competitive Advantage by MNEs
In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.
The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

19. Competitive Advantages of MNCs
Economies of Scale and Scope
Managerial and Marketing Expertise
Advanced Technology
Financial Strength
Differentiated products
Competitiveness of Home market

20. supporting Industries
Exhibit Determinants of National Competitive Advantage: Porter’s Diamond
(1)
Factor conditions
(4)
Firm strategy,
structure, & rivalry
(2)
Demand
conditions
(3)
Related and
supporting Industries
Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990.

21. The OLI Paradigm and Internalization
The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.
“O” owner-specific (competitive advantage in the home market that can be transferred abroad)
“L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage)
“I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)

22. Where to Invest?
The decision about where to invest abroad is influenced by behavioral factors.
The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.
In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.
In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

23. Where to Invest?....
The decision to invest abroad is often a stage in the firm’s development process.
Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad.
Some important external stimuli are:
An outside proposal, from a quality source
Fear of losing a market
The “bandwagon” effect
Strong competition from abroad in the home market

24. How to Invest Abroad: Modes of Foreign Involvement
The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities.
The following exhibit provides a roadmap to explain this FDI sequence.

25. Exhibit 15.9 The FDI Sequence: Foreign Presence & Foreign Investment
The Firm and its
Competitive Advantage
Greater Foreign Presence
Change
Competitive Advantage
Exploit Existing Competitive
Advantage Abroad
Greater
Foreign
Investment
Production at Home:
Exporting
Production Abroad
Licensing
Management Contract
Control Assets
Abroad
Joint Venture
Wholly-Owned
Affiliate
Greenfield
Investment
Acquisition of a
Foreign Enterprise

26. Modes of Foreign Involvement
Exporting Vs production Aboard
Licensing and Management Contracts Vs Control of Assets Abroad
Joint venture Vs Wholly Owned Subsidiary
Greenfield Investment Versus Acquisition
Strategic Alliances

27. Exporting versus production abroad:
There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks
The amount of front-end investment is typically lower than other modes of foreign involvement
Some disadvantages include the risks of losing markets to imitators and global competitors

28. Licensing and management contracts versus control of assets abroad:
Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds
However, there are disadvantages which include:
License fees are lower than FDI profits
Possible loss of quality control
Establishment of a potential competitor in third-country markets
Risk that technology will be stolen

29. Licensing and management contracts versus control of assets abroad….
Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure
Management contracts probably lessen political risk because the repatriation of managers is easy

30. Joint venture versus wholly owned subsidiary
A joint venture is here defined as shared ownership in a foreign business
Some advantages of a MNE working with a local joint venture partner are:
Better understanding of local customs, mores and institutions of government
Providing for capable mid-level management
Some countries do not allow 100% foreign ownership
Local partners have their own contacts and reputation which aids in business

31. Joint venture versus wholly owned subsidiary
However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:
Increased political risk if the wrong partner is chosen
Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)
Transfer pricing issues
Difficulties in the ability to rationalize production on a worldwide basis

32. Greenfield investment versus acquisition
A Greenfield investment is defined as establishing a production or service facility starting from the ground up
Compared to a Greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names
Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

33. strategic alliance
The term strategic alliance conveys different meanings to different observers.
In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.
A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service
Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

34. FDI In
Bangladesh

35. Desired Foreign Investment Categories
Export oriented industries
Industries in the Export processing Zones
High technology products that will be either import substitute or export oriented
Undertaking in which more diversified use of indigenous natural resources is possible
Basic industries based mainly on local raw materials

36. Prohibited sector of FDI in Bangladesh
Arms and ammunition and other defense equipment and machinery
Forest plantation and mechanized extraction within the bounds of reserved forests
Production of nuclear energy and
Security printing and mining