INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
15Chapter FifteenForeign Direct Investment
Chapter Objective:
This chapter discusses various issues associated with
foreign direct investments by MNCs,which play a
key role in shaping the nature of the emerging global
economy.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-1
Chapter Outline
? Global Trends in FDI
? Why Do Firms Invest Overseas?
? Cross-Border Acquisitions
? Political Risk and FDI
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-2
Global Trends in FDI
? Foreign Direct Investment often involves the
establishment of production facilities abroad.
? Greenfield Investment
? Involves building new facilities from the ground up.
? Cross-Border Acquisition
? Involves the purchase of existing business.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-3
Global Trends in FDI
? Several developed nations are the sources of FDI
outflows.
? About 90% of total world-wide FDI comes from the
developed world.
? Both developing and developed nations are the
recipient of inflows of FDI.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-4
Average Annual FDI (in Billions)
0
20
40
60
80
100
120
A
u
s
t r
a
l i
a
C
a
n
a
d
a
C
h
i n
a
Fr
a
n
c
e
G
e
r m
a
n
y
I t
a
l y
J
a
p
a
n
M
e
x
i c
o
N
e
t h
e
r l
a
n
d
s
S
p
a
i n
S
w
e
d
e
n
S
w
i t
z
e
r l
a
n
d
U
n
i t
e
d
K
i n
g
d
o
m
U
n
i t
e
d
S
t a
t e
s
I n f l o w s
O u t f l o w s
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-5
Why Do Firms Invest Overseas?
? Trade Barriers
? Labour Market Imperfections
? Intangible Assets
? Vertical Integration
? Product Life Cycle
? Shareholder Diversification
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-6
Trade Barriers
? Government action leads to market imperfections.
? Tariffs,quotas,and other restrictions on the free
flow of goods,services and people.
? Trade Barriers can also arise naturally due to high
transportation costs,particularly for low value-to-
weight goods.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-7
Labour Market Imperfections
? Among all factor markets,the labor market is the
least perfect.
? Recall that the factors of production are land,labor,
capital,and entrepreneurial ability.
? If there exist restrictions on the flow of workers
across borders,then labor services can be
underpriced relative to productivity.
? The restrictions may be immigration barriers or simply
social preferences.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-8
Labour Market Imperfections
C o untr y Hour ly Co st
Ger many $ 2 7,37
Japan $ 2 1,38
F ra nce/U.S,$ 1 7,10
Is ra el $ 9,06
Ta iw a n $ 5,47
Mex ico $ 2,57
Persistent wage
differentials across
countries exist,This
is one on the main
reasons MNCs are
making substantial
FDIs in less
developed nations.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-9
Intangible Assets
? Coca-Cola has a very valuable asset in its closely
guarded,secret formula”.
? To protect that proprietary information,Coca-Cola
has chosen FDI over licensing.
? Since intangible assets are difficult to package and
sell to foreigners,MNCs often enjoy a
comparative advantage with FDI.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-10
Vertical Integration
? MNCs may undertake FDI in countries where
inputs are available in order to secure the supply
of inputs at a stable accounting price.
? Vertical integration may be backward or forward:
? Backward,e.g,a furniture maker buying a logging
company.
? Forward,e.g,a U.S,auto maker buying a Japanese auto
dealership.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-11
Product Life Cycle
? U.S,firms develop new products in the developed
world for the domestic market,and then markets
expand overseas.
? FDI takes place when product maturity hits and
cost becomes an increasingly important
consideration for the MNC.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-12
Product Life Cycle
Qu
an
tity
Qu
an
tity
The U.S.
Less advanced
countries
production
New product Maturing product Standardized product
New product Maturing product Standardized product
exports imports
production
imports
exports
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-13
Shareholder Diversification
? Firms may be able to provide indirect
diversification to their shareholders if there exists
significant barriers to the cross-border flow of
capital.
? Capital Market imperfections are of decreasing
importance,however.
? Managers can therefore probably not add value by
diversifying for their shareholders as the
shareholders can do so themselves at lower cost.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-14
Cross-Border Acquisitions
? Greenfield Investment
? Building new facilities from the ground up.
? Cross-Border Acquisition
? Purchase of existing business.
? Cross-Border Acquisition represents 40-50% of FDI
flows.
? Cross-border acquisitions are a politically
sensitive issue:
? Greenfield investment is usually welcome.
? Cross-border acquisition is often unwelcome.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-15
Political Risk and FDI
? Unquestionably this is the biggest risk when
investing abroad.
?,Does the foreign government uphold the rule of
law?” is a more important question than normative
judgements about the appropriateness of the
foreign government’s existing legislation.
? A big source of risk is the non-enforcement of
contracts.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-16
Political Risk and FDI
? Macro Risk
? All foreign operations put at risk due to adverse
political developments.
? Micro Risk
? Selected foreign operations put at risk due to adverse
political developments.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-17
Political Risk
? Transfer Risk
? Uncertainty regarding cross-border flows of capital.
? Operational Risk
? Uncertainty regarding host countries policies on firm’s
operations.
? Control Risk
? Uncertainty regarding expropriation.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-18
Hedging Political Risk
? Geographic diversification
? Simply put,don’t put all of your eggs in one basket.
? Minimize exposure
? Form joint ventures with local companies.
?Local government may be less inclined to expropriate assets
from their own citizens.
? Join a consortium of international companies to
undertake FDI.
?Local government may be less inclined to expropriate assets
from a variety of countries all at once.
? Finance projects with local borrowing.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-19
Hedging Political Risk
? Insurance
? The Overseas Private Investment Corporation (OPIC)
a U.S,government federally owned organization,
offers insurance against:
1,The inconvertibility of foreign currencies.
2,Expropriation of U.S.-owned assets.
3,Destruction of U.S.-owned physical properties due to war,
revolution,and other violent political events in foreign
countries.
4,Loss of business income due to political violence
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
15-20
End Chapter Fifteen