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Chapter 18 Foreign Direct Investment and International Capital Budgeting.

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Presentation on theme: "Chapter 18 Foreign Direct Investment and International Capital Budgeting."— Presentation transcript:

1 Chapter 18 Foreign Direct Investment and International Capital Budgeting

2 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To discuss the characteristics and development of FDI. To outline the theories of FDI. To describe the techniques of international capital budgeting. To examine the implications of taxation, country risk and transfer prices for international capital budgeting.

3 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Definition An investment project is classified as direct investment if the investor acquires ‘significant control’ over a firm.

4 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 What is ‘Significant Control’ ? Ownership of 10-25% United States, Japan and Australia: 10% France, Germany and United Kingdom: higher threshold Belgium and the Netherlands: no specific number

5 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Reasons for Interest in FDI Rapid growth and changing pattern of FDI Concern about causes and consequences of foreign ownership FDI channels resources to developing countries The role played in transforming ex- communist countries

6 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 FDI in the Nineteenth Century FDI was prominent, but it mostly took the form of lending by Britain to other countries.

7 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 FDI in the Interwar Period Foreign investment declined, but direct investment rose. Britain lost its status as the major creditor.

8 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 FDI in the Post-World War II Period FDI started to grow for two reasons:  Improvements in transport and telecommunications  Need of European countries and Japan for US assistance

9 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 FDI in the 1960s Reversal of trend:  Host countries started to show resistance to US ownership of enterprises  Host countries started to recover, initiating FDI in the United States

10 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 FDI in the 1970s Lower FDI flows The United Kingdom appeared as a major player

11 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 FDI in the 1980s The United States became a net debtor. Japan emerged as a major source of FDI. The surge in FDI was due to the globalisation of business.

12 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 FDI in the 1990s FDI declined in 1990-1992 but rebounded subsequently because:  FDI is no longer confined to large firms  The sectoral diversity of FDI has broadened  The number of countries involved has risen

13 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 FDI in the 1990s (cont.) The decline in the importance of Japan as a source of FDI The late 1990s were characterised by the rising popularity of cross-border mergers and acquisitions (M&As)

14 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Inward and Outward FDI Inward FDI is when a foreign country invests in the country in question. Outward FDI is when the home country invests abroad.

15 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 FDI Flows Equity capital Reinvested earnings Intra-company loans

16 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 FDI Stocks The value of capital and reserves (including retained earnings) attributable to the parent firm, plus the net indebtedness of its subsidiaries

17 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Australian FDI Flows (USD Billion)

18 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Australian FDI Stocks (USD Billion)

19 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Cross-Border Mergers and Acquisitions

20 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Modes of Foreign Market Entry Export of the goods produced in the source country Licensing a foreign company to use technology Foreign distribution of products through a subsidiary Foreign (international) production

21 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Choice Between Exporting and FDI Profitability Opportunities for market growth Production cost levels Economies of scale

22 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Licensing This involves the supply of technology and know-how or the use of a trademark or a patent for a fee. It offers one way to generate revenue from foreign markets that are otherwise inaccessible.

23 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Franchising Companies with brand-name products move offshore by granting foreigners the exclusive right to sell their products in a designated area.

24 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Types of FDI Greenfield investment Brownfield investment Mergers and acquisitions Joint ventures

25 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Choice Between Greenfield Investment and M&As Firms with lower R&D intensity, more diversified firms and large multinationals are more inclined to indulge in M&As. Inter-country cultural and economic differences reduce the tendency for M&As.

26 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Choice Between Greenfield Investment and M&As (cont.) Multinationals with subsidiaries prefer acquisitions. The tendency for M&As depends on the supply of target firms. Slow growth in an industry encourages M&As.

27 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 Theories of FDI A number of theories or hypotheses have been put forward to explain FDI.

28 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 The Differential Rates of Return Hypothesis Capital flows from countries with low rates of return to countries with high rates of return.

29 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 The Diversification Hypothesis The choice among various projects is determined by expected return and risk.

30 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 The Output and Market Size Hypothesis The volume of direct investment in one host country depends on sales or market size.

31 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 The Industrial Organisation Hypothesis A firm indulges in FDI despite inter-country differences because it has some advantages such as brand name, patent, managerial skills, etc.

32 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 The Internalisation Hypothesis FDI arises from efforts by firms to replace market transactions with internal transactions.

33 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 The Location Hypothesis FDI exists because of the international immobility of some factors of production.

34 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 The Eclectic Theory Three conditions must be satisfied if a firm is to engage in FDI:  It must have comparative advantages  It is better to use rather than lease these advantages  It is more profitable to use these advantages with factor inputs abroad

35 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 The Product Life Cycle Hypothesis When a product is standardised, the innovator may decide to invest in developing countries to obtain some advantages, such as cheap labour.

36 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 The Oligopolistic Reaction Hypothesis FDI by one firm triggers similar investment by other leading firms in an attempt to maintain market share.

37 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 The Internal Financing Hypothesis FDI is determined by the foreign subsidiaries’ internally generated funds.

38 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 The Currency Areas Hypothesis Countries with strong currencies tend to be sources of FDI. Countries with weak currencies tend to be recipients of FDI.

39 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 39 Diversification with Barriers to Capital Flows FDI arises from the desire to diversify through two conditions:  Barriers or costs to portfolio flows  Multinationals provide diversification opportunities

40 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 40 Political Stability and Risk Lack of political stability discourages FDI inflows. Political risk arises because of unexpected modifications of the legal and fiscal framework in the host country.

41 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 41 Tax Policies Tax policies affect incentives to engage in FDI because:  Tax treatment of income generated abroad affects the rate of return  Tax treatment of income generated at home affects relative profitability  Tax policies affect the relative cost of capital

42 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 42 Government Regulations Regulations may provide incentives (e.g. tax credits and exemptions). Regulations may provide disincentives (e.g. slow processing of required authorisation).

43 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 43 Strategic and Long-term Factors The desire to defend foreign markets against competitors The desire to gain and maintain a foothold in a protected market The need to develop a parent-subsidiary relationship

44 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 44 Strategic and Long-term Factors (cont.) The desire to induce the host country into a long-term commitment to a particular type of technology The advantage of complementing another type of investment

45 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 45 Strategic and Long-term Factors (cont.) The economies of new product development Competition for market shares among oligopolists

46 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 46 Evaluating Direct Investment Projects Accounting rate of return Payback period Net present value (NPV) Internal rate of return (IRR)

47 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 47 Accounting Rate of Return This is the percentage return on capital. The method is criticised because:  It is based on profit rather than cash flows.  It ignores the size of the project and the time value of money.

48 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 48 Payback Period This measures how quickly the cost is recovered. It is based on cash flows. It ignores the time value of money and the cash flows arising after the payback period.

49 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 49 Net Present Value

50 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 50 Internal Rate of Return

51 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 51 Adjusting Project Assessment for Risk Risk-adjusted discount rate Risk-adjusted cash flows Sensitivity analysis

52 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 52 Evaluating FDI Projects Two problems:  Measurement of cash flows  Choice of discount rate

53 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 53 Problems of Cash Flow Measurement Cash flows accruing to the parent company and the subsidiary are different because:  Different tax rates  Restrictions on remittances  Excessive remittances  Changes in exchange rates

54 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 54 Forecasting Cash Flows Demand for the product Price of the product Variable costs Fixed costs Project lifetime

55 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 55 Forecasting Cash Flows (cont.) Salvage value Remittance restrictions Tax rates and laws Exchange rates

56 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 56 The Evaluation Process Estimating incremental cash flows Estimating remittable cash flows in domestic currency Incorporating indirect costs and benefits Discounting cash flows

57 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 57 The Cost of Capital This is the minimum risk-adjusted rate of return required in order for the investment to be accepted. It is used as a discount rate for future cash flows.

58 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 58 The Cost of Capital for Multinationals This is likely to be different from that of domestic firms because multinationals:  Receive preferential treatment  Have better access to international capital markets  Are more diversified  Have volatile cash flows

59 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 59 The APV Technique The following items are taken into account:  Remittable cash flows  Tax savings and subsidies  Effect on corporate debt capacity  Other cash flows

60 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 60 International Taxation This is the taxation of cross-border transactions. Double taxation arises if income earned abroad is taxed at home and abroad.

61 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 61 Approaches to International Taxation Classic approach: income received by each taxable entity is taxed. Integrated approach: aims at eliminating double taxation by:  Taxing undistributed earnings at a higher rate  Imputation tax system

62 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 62 Types of Taxes Corporate income tax Withholding taxes Indirect taxes Import duties Taxes on FX gains

63 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 63 Avoiding Double Taxation Many countries have bilateral tax treaties with other countries. The OECD has developed a model tax convention. One way of avoiding double taxation is tax credits.

64 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 64 Tax Havens A tax haven is a place where foreigners may receive income or own assets without paying taxes on them.

65 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 65 Country Risk This arises because of the possibility of losses due to country-specific economic, political and social events. It encompasses political risk and sovereign risk.

66 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 66 Sovereign Risk The possibility of losses on claims on foreign governments and their agencies

67 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 67 Political Risk The possibility of losses due to changes in the rules governing FDI, as well as adverse political developments

68 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 68 Political Risk: Confiscation Confiscation does not involve proper compensation. Expropriation implies compensation.

69 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 69 Incorporating Country Risk into Capital Budgeting Adjusting expected cash flows or the discount rate Measuring the effects of country risk as the value of an insurance policy Using option pricing to derive the price of country risk

70 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 70 Transfer Pricing The pricing of goods and services that are bought and sold (transferred) between members of a corporate family

71 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 71 Setting Transfer Prices Tax considerations Global regulation Management incentives and performance evaluation Marketing considerations and competition

72 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 72 Setting Transfer Prices (cont.) Risk and uncertainty Government policies The interests of joint venture partners The negotiating power of the subsidiary


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