Part IV

Long-Term Asset and Liability Management

Potential
Revision in
Host Country
Tax Laws or
Other
Provisions
MNCs Access
to Foreign
Financing
International
Interest Rates
on Long-Term
Funds

Existing
Host Country
Tax Laws
Exchange
Rate
Projections
Country Risk
Analysis
MNCs Cost
of Capital
Risk Unique to
Multinational
Project

Estimated
Cash Flows of
Multinational
Project
Multinational
Capital
Budgeting
Decisions
Required
Return on
Multinational
Project

13

Chapter

Direct Foreign Investment

South-Western/Thomson Learning 2006

Slides by Yee-Tien (Ted) Fu

Chapter Objectives
To describe common motives for initiating
direct foreign investment (DFI); and

To illustrate the benefits of international

diversification.

13 - 3

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.

13 - 4

Revenue-Related Motives for DFI

Motives

Means of Achieving Benefit

Attract new sources

of demand.

Establish a subsidiary or acquire

a competitor in a new market.

Enter profitable
markets.

Acquire a competitor that has

controlled its local market.

Exploit
monopolistic
advantages.

Establish a subsidiary in a market

where competitors are unable to
produce the identical product.

React to trade
restrictions.

Establish a subsidiary in a market

where trade restrictions will
adversely affect export volume.

Diversify
internationally.

Establish subsidiaries in markets

with different business cycles.
13 - 5

Cost-Related Motives for DFI

Motives

Means of Achieving Benefit

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.

Use foreign factors

of production.

Establish a subsidiary in a market

that has lower costs of labor or
land. Sell the products elsewhere.

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.
13 - 6

Cost-Related Motives for DFI

Motives

Means of Achieving Benefit

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.

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.

13 - 7

Motives for DFI

The European Unions 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.
13 - 8

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.

13 - 9

Comparing the Benefits of DFI

Across Countries
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 countrys economic growth and
other macroeconomic indicators, as well as
the political structure and policy issues.

13 - 10

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.

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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.

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Diversification Benefits for

Merrimack Co.
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.
Projects mean expected
annual after-tax return

25%

25%

Standard deviation of
projects return

.09

.11

Correlation of projects
return with return on
existing U.S. business

.80

.02
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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.
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Diversification Benefits for

Merrimack Co.
Suppose that the project will constitute
30% of Merrimacks 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
w A2 2A w B2 B2 2w Aw B A BCORR AB

.70 2.10 2 .30 2.09 2 2.70 .30 .10 .09 .80

.008653
13 - 15

Diversification Benefits for

Merrimack Co.
If the new project is located in the U.K.,
the portfolio variance for the overall firm

w A2 2A w B2 B2 2w Aw B A BCORR AB

.70 .10 .30 .11 2 .70 .30 .10 .11.02

.0060814
2

Thus, as a whole, Merrimack will generate

more stable returns if the new project is
located in the U.K.
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Diversification Analysis of
International Projects
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.

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Expected Return

Risk-Return Analysis of
International Projects
Frontier of efficient
project portfolios

A
B
C

D
E

Project A has
the highest
expected
return and
greatest risk.

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.
13 - 18

Diversification Analysis of
International Projects
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.
13 - 19

Diversification Analysis of
International Projects
Some MNCs have frontiers of possible

Expected Return

project portfolios that are more desirable

than the frontiers of other MNCs.
Efficient frontier for
a multiproduct
MNC
Efficient frontier
for a singleproduct MNC
Risk
13 - 20

Diversification Analysis of
International Projects
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.

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Comparison of Economic Growth Among Countries

13 - 22

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.

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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.

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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.
13 - 25

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.
13 - 26

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.

13 - 27