1 CONTENTS OF 3 RD UNIT 3. MULTINATIONAL CORPORATE DECISIONS IN GLOBAL MARKETS...............4 3.1. FOREIGN INVESTMENT DECISIONS:..................................4 3.2. FOREIGN DIRECT INVESTMENT (FDI)................................5 3.2.1. MEANING AND DEFINITION OF FDI..............................5 3.2.2. TYPES OF FOREIGN DIRECT INVESTMENT.........................5 3.2.3. FACTORS/DETERMINANTS OF FOREIGN DIRECT INVESTMENT..........6 3.2.4. MOTIVES OF FOREIGN DIRECT INVESTMENT:......................8 3.2.5. RESOURCES AND METHODS FOR MAKING FDI:.....................10 3.2.6. STRATEGY FOR FDI:.........................................11 3.2.7. MEASURES TO ATTRACT FDI INFLOWS INTO THE COUNTRY:.........13 3.2.8. FOREIGN DIRECT INVESTMENT THEORIES:.......................13 3.2.8.1. Theory of Comparative Advantage/Porter’s Diamond Model: National Competitive Advantage Theory:.........................14 3.2.8.2. OLI/Dunning’s Eclectic Paradigm/Eclectic Theory:.......16 3.2.8.3. Monopolistic Advantage Theory:.........................17 3.2.8.4. Internalization Theory:................................18 3.2.9. MODES OF FOREIGN INVESTMENT:..............................19 3.2.9.1. Licensing:.............................................19 3.2.9.2. Management contracts...................................20 3.2.9.3. Joint Ventures:........................................21 3.2.9.4. Greenfield Investment:.................................22 3.2.9.5. Acquisitions:..........................................23 3.2.9.6. Strategic Alliances:...................................23 3.2.9.7. Exporting:.............................................24 3.2.9.8. Franchising............................................26 3.2.9.9. Turnkey Contracts:.....................................27 3.2.10...................................COSTS AND BENEFITS OF FDI: 27
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CONTENTS OF 3RD UNIT3. MULTINATIONAL CORPORATE DECISIONS IN GLOBAL MARKETS........................................................4
3.2. FOREIGN DIRECT INVESTMENT (FDI)..........................................................................................5
3.2.1. MEANING AND DEFINITION OF FDI......................................................................................5
3.2.2. TYPES OF FOREIGN DIRECT INVESTMENT............................................................................5
3.2.3. FACTORS/DETERMINANTS OF FOREIGN DIRECT INVESTMENT............................................6
3.2.4. MOTIVES OF FOREIGN DIRECT INVESTMENT:......................................................................8
3.2.5. RESOURCES AND METHODS FOR MAKING FDI:.................................................................10
3.2.6. STRATEGY FOR FDI:............................................................................................................11
3.2.7. MEASURES TO ATTRACT FDI INFLOWS INTO THE COUNTRY:.............................................13
3.2.8. FOREIGN DIRECT INVESTMENT THEORIES:........................................................................13
3.2.8.1. Theory of Comparative Advantage/Porter’s Diamond Model: National Competitive Advantage Theory:........................................................................................................................14
3.9.1. MEANING OF PROJECT FINANCE........................................................................................66
3.9.2. SOURCES OF PROJECT FINANCE.........................................................................................66
3.9.3. INSTRUMENTS OF PROJECT FINANCING............................................................................67
3.9.4. ADVANTAGES OF PROJECT FINANCING..............................................................................70
3.9.5. DISADVANTAGES OF PROJECT FINANCING........................................................................71
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3. MULTINATIONAL CORPORATE DECISIONS IN GLOBAL MARKETS
3.1. FOREIGN INVESTMENT DECISIONS:Foreign investment is a type of investment that involves purchasing securities that originate in other countries. This type of investment is popular because it can provide diversification and opportunities for superior growth. There are many different ways to invest internationally including through mutual funds, Exchange Traded Funds (ETFs) and American depository receipts. International investing is a procedure that many investors choose to get involved in by investing money outside of their domestic market. For example, instead of holding a portfolio of only domestic stocks and bonds, an investor could purchase some stocks from a foreign country or buy shares of a mutual fund that specializes in international investment.
Foreign investment decision is a tough and often complex investment decision that sharply differs from the traditional domestic decision on investing. Foreign investment decisions consist of a complex process that differs in many respects from domestic investment decisions. The complexity arises from different sets of strategic, motivational, and economic considerations far wider than a better known domestic market environment. Foreign investment is normally overshadowed by political and foreign exchange risk considerations, surpassed by longer process, cost overruns, and less familiarity with the participating market. What motivates a corporation to enter the foreign market is the intuition of higher earnings potential, the saturation of the domestic market, or the forces of market competition and customers’ demand for a greater variety of services on a worldwide basis. Banks, like any other industrial corporation, are faced with a similar challenge. In fact, in some respects, they see a greater challenge than manufacturing or other service industries because the nature of the banking business requires far more liquidity than other business structures.
Foreign investment decision is a decision to invest abroad takes a concrete shape when a future project is evaluated in order to ascertain whether the implementation of the project is going to add to the value of the investing company. The evaluation of the long-term investment project is known as capital budgeting. The technique of capital budgeting is almost similar between a domestic company and an international company. The only difference is that some additional complexities appear in the case of international capital budgeting. These complexities influence the computation of the cashflow and the required rate of return.
Foreign investment or capital flows fall into following categories:
1) Foreign Direct Investment (FDI): Pertains to international investment in which the investor obtains a lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants, or equipment.
2) International Portfolio Investment (FPI): On the other hand is a category of investment instruments that is more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise which does not necessarily represent a long-term interest.
Investment, know-how technology, management
Profits, royalties and feesInvestor
(Domestic)Recipient(Foreign)
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3.2. FOREIGN DIRECT INVESTMENT (FDI)3.2.1. MEANING AND DEFINITION OF FDICapital flows in the form of foreign direct investment (FDI) have been widely believed to be an important source of growth in recent year, FDI is the process whereby residents of one country (the source country) acquire ownership of assets for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country). '
The International Monetary Fund’s Balance of Payments Manual defines FDI as, “An investment that is j made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor’s purpose being to have an effective voice in the management of the enterprise”.
The United Nation’s World Investment Report (UNCTAD, 1999) defines FDI as, “An investment involving a long-term relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct investor or parent* enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDl enterprise, affiliate enterprise or foreign affiliate)”.
The term “long-term” is used in the last definition in order to distinguish FDI from portfolio investment; FDI does not have the portfolio investment characteristic of being short-term in nature, involving a high turnover of securities,
foreign direct investment (FDI) is permitted under the following forms of investments:
1) Through joint ventures, financial and technical collaborations,2) Through capital markets via Euro issues,3) Through private placements or preferential allotments.
3.2.2. TYPES OF FOREIGN DIRECT INVESTMENTFollowing are the types of foreign direct investment:
Types of Foreign Direct Investment
Mergers and Acquisition
Horizontal Foreign Direct Investment
Greenfield Investment
Vertical Foreign Direct Investment
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1) Horizontal Foreign Direct Investment: Horizontal FDI refers to the -foreign manufacturing of products and services roughly similar to those the firm produces in its home market. This type %f FDI is called “horizontal” because the multinational duplicates the same activities in different countries. Horizontal FDI arises because it is too costly to serve the foreign market by exports due Jo transportation costs or trade barriers.
2) Vertical Foreign Direct Investment: Vertical FDI refers to those multinationals that fragment production process geographically. It is called ‘^vertical" because MNE separates the production chain vertically by outsourcing some production stages abroad. The basic idea behind the analysis of this type of FDI is that a production process consists of multiple stages with different input requirements. If input prices varies across countries, it becomes profitable for the firm to split the production chain.
3) Greenfield Investment: Greenfield investment refers to a scenario where a national firm becomes multinational. This means that if a national firm in country A becomes multinational, then there is one less national firm in country A and one more firm producing in country B. Three hypotheses can be made for why a firm may become multinational. The number of multinationals producing in a country or market, relative to the number of national firms will be greater as trade barriers increase, plant-level fixed costs decrease, and the host country market grows. As long as barriers to trade are high, that is trade openness is low and trade costs are low, then firms have an incentive to undertake Greenfield investment.
4) Mergers and Acquisition: The other form of horizontal FDI is a merger and acquisition. This type of investment occurs when an existing firm takes over or merges with a foreign firm, this form of FDI is modeled by a national firm in country A changing to become a multinational firm headquartered in country A, together with a takeover and disappearance of a firm in country B.
3.2.3. FACTORS/DETERMINANTS OF FOREIGN DIRECT INVESTMENT
The volume of FDI in a country depends on the following factors:
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1) Rate of Return on the Underlying Project: The differential rates of hypothesis represent one of the first attempts to explain FDI flows. This hypothesis postulates that capital flows from countries with low rates of return to countries with high rates of return move in a process that eventually leads to the equality of ex ante real rates of return.
2) Return and risk: When the assumption of risk neutrality is relaxed, risk becomes another variable upon which the FDI decision is made. If this proposition is accepted, then the differential rates of return hypothesis become inadequate, in which case we resort to the diversification (or portfolio) hypothesis to explain FDI.
3) Natural Resources: Availability of natural resources in the host country is a major determinant of FDI. Most foreign investors seek an adequate, reliable and economical source of minerals and other materials, FDI tends to flow in countries which are rich in resources but lack capital, technical skills and infrastructure required for the exploitation of natural resources. Though their relative importance has declined, the availability of natural resources still continues to be an important determinant of FDI
4) Availability of Cheap Labour: The availability of low cost unskilled labour has been a major course of FDI in countries like China and India. Low cost lab our together with availability of cheap raw materials enables foreign investors to minimize costs of production and thereby increase profits.
5) Market Size: The volume of FDI in a host country depends on its market size. This hypothesis is particularly valid for the case of import-substituting FDI. As soon as the size of the market of a particular country has grown to a level warranting the exploitation of economies of scale, this country becomes a potential target for FDI inflows.
6) Socio-Economic Conditions: Size of the population, infrastructural facilities and income level of a country influence direct foreign investment...
7) Political Situation: Political stability, legal framework, judicial system, relations with other countries and, other political factors influence movements of capital from one country to another.
8) Need for Internalization: According to the internalization hypothesis, FDI arises from efforts by firms to replace market transactions with internal transactions. For example, if there are problems associated with buying oil products on the market, a firm may decide to buy a foreign refinery. These problems arise from imperfections and failure of markets for intermediate goods, including human. Capital, knowledge, marketing and management expertise.
9) International Immobility of Factors of Production: According to the location hypothesis, FDI exists because of the international immobility of some factors of production such as labor and natural resources. This immobility leads to location-related differences in the costs of factors of production.
10) Strategic and Long-Term Factors: Some strategic and long-term factors have been put forward to explain FDI. These factors include the following:
i). The desire on the part of the investor to defend existing foreign markets and foreign investments against competitors.
ii). The desire to gain and maintain a foothold in a protected market or to gain and maintain a source of supply that may prove useful in the long-run.
iii). The need to develop and sustain a parent-subsidiary relationship.
Motives of Foreign Direct Investment
Revenue-Related MotivesCost-Related Motives
Attract New Sources of Demand
Enter Profitable Markets
Exploits Monopolistic Advantages
React to Trade Restrictions
Diversify Internationally
Fully Benefit from Economies of Scale
Use Foreign Factors of Production
Use Foreign Raw Materials
Use Foreign Technology
React to Exchange Rate Movements
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iv). The desire to induce the host country into a long commitment to a particular type of technology.
v). The advantage of complementing another type of investment.vi). The economies of new product development.
vii). Competition for market shares among oligopolistic and the concern for strengthening bargaining positions.
3.2.4. MOTIVES OF FOREIGN DIRECT INVESTMENT:
MNCs commonly consider foreign direct investment because it can improve their profitability and enhance shareholder wealth. In most cases, MNCs engage in FDI because they are interested in boosting revenues, reducing costs, or both:
1) Revenue-Related Motives: The following are typical motives of MNCs that are attempting to boost revenues:
i). Attract New Sources of Demand: 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.
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Many developing countries, such as Argentina, Chile, Mexico, Hungary, and China, have been perceived as attractive sources of new demand. 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.
ii). 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.
iii). 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.
iv). React-to Trade Restrictions: In some cases, MNCs use DFI as a defensive rather than an aggressive strategy. Specifically, MNCs may pursue DFI to circumvent trade barriers.
v). Diversify Internationally: Since economies of countries do not move perfectly in tandem over time, net cashflow from sales of products across countries should be more stable than comparable sales of the products in a single country. By diversifying (and possibly even production) internationally, a firm can make its net cashflows less volatile. Thus, the possibility of a liquidity deficiency is less likely. In addition, the firm may enjoy a lower cost of capital as shareholders and creditors perceive the MNC’s risk to be lower as a result of more stable cashflows.
2) Cost-Related Motives: MNCs also engage in DFI in an effort to reduce costs. The following are typical motives of MNCs that are trying to cut costs:
i). Fully Benefit from Economies of Scale: A corporation that attempts to sell its primary product in new markets may increase its earnings and shareholder wealth due to economies of scale (lower average cost per unit resulting from increased production). Firms that utilize much machinery are most likely to benefit from economies of scale.
ii). Use Foreign Factors of Production: Labor and land costs can vary dramatically among countries. MNCs often attempt to set-up production in locations where land and labor are cheap. Due to market imperfections such as imperfect information, relocation transaction costs, and barriers to industry entry, specific labor costs do not necessarily become equal among markets. Thus, it is worthwhile for MNCs to survey markets to determine whether they can benefit from cheaper costs by producing in those markets.
iii). Use Foreign Raw Materials: Due to transportation costs, a corporation may attempt to avoid importing raw materials from a given country, especially when it plans to sell the finished product back to consumers in that country. Under such circumstances, a more feasible solution may be to develop the product in the country where the raw materials are located.
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iv). Use Foreign Technology: Corporations are increasingly establishing overseas plants or acquiring existing overseas plants to learn the technology of foreign countries. This technology is then used to improve their own production processes and increase production efficiency at all subsidiary plants around the world.
v). React to Exchange Rate Movements: When a firm perceives that a foreign currency is undervalued, the firm may consider DFI in that country, as the initial outlay should be relatively low.
A related reason for such DFI is to offset the changing demand for a company’s exports due to exchange rate fluctuations. For example, when Japanese automobile manufacturers build plants in the United States, they can reduce exposure to exchange rate fluctuations by incurring dollar costs, for their production that offset dollar revenues. Although MNCs do not engage in large projects simply as an indirect means of speculating on currencies, the feasibility of proposed projects may be dependent on existing and expected exchange rate movements.
3.2.5. RESOURCES AND METHODS FOR MAKING FDI:
Following are the resources and methods used for making FDI:
1) Assets Employed: Foreign direct investment is usually an international capital movement that crosses borders when the anticipated return (accounting for the risk factor and the cost of transfer) is higher overseas than at home. Although most FDI requires some type of international capital movement, an investor may transfer many other types of assets. For example, Westin Hotels has transferred very little capital to foreign countries Instead, it has transferred managers, cost control systems and reservations capabilities in exchange for ownership in foreign hotels.
2) Buy-Versus-Build Decisioni). Reasons for Buying: Whether a Company makes a direct investment by acquisition or
start-up depends, of course, on which companies areavailableT&Kßurchase. The large privatization programs occurring in many parts of the world have put hundreds of companies on the market and MNEs have exploited this new opportunity to invest abroad. For example, foreign companies, such as Vivendi from France, bought many British utility companies when they were privatized.There are many reasons for seeking acquisitions. One is the difficulty of transferring some resource to a foreign operation or acquiring that resource locally for a new facility, especially if the company feels it needs to adapt substantially to the local environment or operate through a multi-domestic strategy. Personnel are a resource that foreign companies may find difficult to hire, especially if local unemployment is low. Instead of paying higher compensation than competitors do to entice employees away from their old jobs; a company can buy an existing company, which gives the buyer, not only labour and management but also an existing organizational structure. This may be particularly important if the company is making an FDI to augment its capabilities, such as to acquire knowledge.Through acquisitions, a company may also gain the goodwill and brand identification important to the marketing of mass consumer products, especially if the cost and risk of
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breaking in a new brand are high. Further, a company that depends substantially oil local financing rather than on the transfer of capital may find it easier to gain access to local capital through an acquisition. Local capital suppliers may be more familiar with an ongoing operation than with the foreign enterprise. In addition, a foreign company may acquire an existing company through an exchange of stock.Finally, by buying a company, an investor avoids inefficiencies during the start-up period and gets an immediate cash flow rather than the problem of tying up funds during construction.
ii). Reasons for Building: Although acquisitions offer advantages, a potential investor will not necessarily be able to realize them. Companies frequently make foreign investments in sectors where there are few, if any, companies operating, so finding a company to buy may be difficult. In addition, local governments may prevent acquisitions because they want more competitors in the market and fear market dominance by foreign enterprises. Even if acquisitions are available, they often do not succeed. The acquired companies might have substantial problems. Personnel and labour relations may be both poor and difficult to change, ill will may have accrued to existing brands or facilities may be inefficient and poorly located.Further, the managers in the acquiring and acquired companies may not work well together, particularly if the two companies are accustomed to different management styles and practices or if the acquiring company tries to institute many changes.
3.2.6. STRATEGY FOR FDI:When a firm decides to operate in a foreign land, it needs to follow a specific strategy in order to make its operation a viable one. The strategy must be designed so as to enable it to have an edge over competing firms. To this end, the firm may concentrate either on product innovation, product differentiation, on the cartels and collusion, or on some other strategies.
In fact, the strategy depends to a great extent on how mature the product is or how designed its cost structure is.
Following are the strategies for FDI:
1) Firm-Specific Strategy: When a firm has already spent a huge sum of money on research and development, it normally stresses on serving the consumers abroad with an innovated product and this gives it a definite edge over competing firms. Such products are generally price-inelastic which helps die firm earn greater profits but the life span of this strategy is limited. After some time, the technology does not remain the exclusive monopoly of the firm and the competing firms too begin to produce similar goods.When the product-innovation strategy fails to work, a firm may adopt a product-differentiation strategy. This is done through putting a trademark on the product, or in other words, through branding the product. Branding substitutes to a great extent the product-innovation strategy, in so far as the branded product enjoys an exclusive status, quite different from similar products in the market.Sometimes the firm adopts different brands for different markets to make them more suitable for a local market on different grounds or to reap market segmentation benefits. For example,
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Unilever’s low-lather fabric washing product is marketed under five different brands in Western Europe.
2) Cost-Economizing Strategy: When a firm’s product becomes standardized and it faces competition from similar products of other firms, the firm tries to locate its subsidiary in a country where either raw material or labor is cheap. Cheapness of these factors of production provides the firm an opportunity to reduce the cost of production and to maintain an edge over other firms. For example, if an MNC invests abroad in the raw material sector, it would be able to get that particular raw material at a lower cost and to export it either to the parent unit or to any other subsidiary. The unit getting cheap raw material will be at a competitive advantage. Again,- it is the availability of cheap labour force in developing countries that has led the US and other multinationals to go for off-shore operations there. Such operations are normally vertical operations where the capital-intensive part of production is located in industrialized countries and labour-intensive part of production is located in the developing world.
3) Strategy of Entering in New Areas: Since the two strategies mentioned above have limited life span, the firm tries to enter a new area where competition is yet to begin. Shapiro (1995) has cited an example of Crown Cork and Seal which is headquartered in Philadelphia and has gone for operation in Thailand, Malaysia, Zambia and Peru making bottle tops and cans. The very reason for its foreign operation was that the field was uncultivated and there was no competition.
4) Cross-Investment Strategy: In some cases, a firm begins its foreign operation not primarily for capturing the foreign market or for reducing the cost of production, but to avoid price cuts by competing firms. If a country a firm sets up a manufacturing or trading unit in country B, there is probability for a country B firm to operate in country A. In such cases, if the former goes for a cut in the price, the latter too will adopt the same strategy as a retaliatory measure.
5) Joint Venture with Rival Firm: Sometimes, when a rival firm in the host country is so powerful that it is not easy for the MNC to compete, the latter prefers to join hands with the host country firm for a joint- venture agreement and the MNC thus is able to penetrate the host-country market.Whatever strategy is adopted by the MNCs abroad, there are certain necessary pre-conditions which are as follows:
i). They should have an idea of the profitable investment opportunities and the ways to tap those opportunities.
ii). Each and every strategy must be carefully evaluated since a particular project may not be competitive on all fronts. If one strategy is not useful, the firm should go in for another strategy.
iii). The firm must evaluate the life span of each strategy. It must possess the flexibility of switching over from one strategy to another, especially when the life span of a particular strategy comes to an end.
6) Mode of Investment: The mode of investment abroad is one of the most crucial strategies. If the mode is not suitable, the investment cannot be a viable venture. However, it may be noted that selection of a particular mode does not depend solely on the wishes of the investing company, but also upon the economic and political environment in the host country. If the host government does not allow a particular mode, the investing company cannot adopt it even if it is the most suitable for it. The most common modes of investment are:
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i). Operation through Branches.ii). Foreign Collaborations:
a) Financial collaboration: Wholly-owned subsidiary. Subsidiary. Affiliate.
b) Technical collaboration Franchise. Turn-key projects. Management contract.
iii). Mergers and Acquisitionsa) Horizontal.b) Vertical.c) Conglomerate.
3.2.7. MEASURES TO ATTRACT FDI INFLOWS INTO THE COUNTRY:
The measures to attract FDI inflows into the country are as follows:
1) Reducing Obstacles: The main measure to attract FDI is to reduce obstacles to FDI by removing restrictions on admission and establishment, as well as on the operations of foreign affiliates. The key issue here is how investment is to be defined for liberalizing entry or offering protection (direct and portfolio capital flows may be treated differently) and what kind of control should be exercised over FDI admission and establishment.
2) Improving Standards: By improving standards of treatment of foreign investors by granting them non- discriminatory treatment about domestic or other foreign investors, one can attract FDI inflows into the country. The key issue here is what degree of national treatment should be granted to foreign affiliates once they are established in a host country.
3) Protection of Foreign Investors: Protecting foreign investors through provisions on compensation in the event of nationalization or expropriation, on dispute settlement and on guarantees on the transfer of funds is one of the ways to attract FDI inflow into the country. A key issue here is how far the right to expropriate or nationalize extends (especially to what extent certain regulatory actions of governments constitute takings of foreign property). Another is the acceptability of the kind of dispute settlement mechanisms available to foreign investors and countries. Third is what restrictions, if any, are acceptable on the ability of governments to introduce capital controls to protect the national economy.
4) Other Measures: Other measures of promoting FDI inflows are that enhance a country’s image, provide I information on investment opportunities, offer location incentives, facilitate FDI by institutional and administrative improvements and render post-investment services. Host countries do most of this, but home countries may also play a role. The key issues here relate to the use of financial, fiscal or other incentives (including regulatory concessions) and the actions that home countries can take to encourage FDI flows to developing countries.
Foreign Direct Investment Theories
Internalization Theory
Theory of Comparative Advantage/Porter’s Diamond Model:
National Competitive Advantage Theory
Monopolistic Advantage Theory
OLI/ Dunning’s Eclectic Paradigm/Eclectic Theory
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3.2.8. FOREIGN DIRECT INVESTMENT THEORIES:The theories of foreign direct investment comprises both ownership and control of international investments I involving real or physical assets such as plants and other facilities, rather than theories regarding other types of I international investment such as portfolios of stocks, bonds, or other forms of debt.
3.2.8.1. Theory of Comparative Advantage/Porter’s Diamond Model: National Competitive Advantage Theory:
The focus of early trade theory was on the country or nation and its inherent, natural, or endowment characteristics that might give rise to increasing competitiveness. As trade theory evolved, it shifted its focus to the industry and product level, leaving the national-level competitiveness question somewhat behind.
Firm Strategy, structure, and rivalry
Related and supporting industries
Demand conditionsFactor Conditions
Chance
Government
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Porter’s Diamond Model for Competitiveness
In 1990, Michael Porter of the Harvard Business School published the results of an intensive research effort that attempted to determine why some nations succeed and others fail in international competition.
These four points, as illustrated in figure 3.2, constitute what nations and firms must strive to “create and sustain through a highly localized process” to ensure their` success.
Components of Porter Diamond
According to porter, a nation’s competitiveness depends on the capacity of its industry to innovate and upgrade.
Porter argued innovation is what drives and sustains competitiveness. A firm must avail itself of all dimensions of competition, which he categorized into four major components of “the diamond of national advantage”.
Figure 3.2 provides an illustration of the complete system of these components and external variables. Each of the four determinants affects the others and all in turn is affected by the role of chance and government.
1) Factor Conditions: The appropriateness of the nation’s factors of production to compete successfully in a specific industry. Porter notes that although these factor conditions are very important in the determination of trade, they are not the only source of competitiveness as suggested by the classical, or factor proportions, theories of trade. Most importantly for Porter,
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it is the ability of a nation to continually create, upgrade, and deploy its factors (such as skilled labor) that are important, not the initial endowment.
2) Demand Conditions: The degree of health and competition the firm must face in its original home market. Firms that can survive and flourish in highly competitive and demanding local markets are much more likely to gain the competitive edge. Porter notes that it is the character of the market, not its size that is paramount in promoting the continual competitiveness of the firm. And Porter translates character as demanding customers.
3) Related and Supporting Industries: The competitiveness of all related industries and suppliers to the firm. A firm that is operating within a mass of related firms and industries gains and maintains advantages through close working relationships, proximity to suppliers, and timeliness of product and information flows. The constant and close interaction is successful if it occurs not only in terms of physical proximity but also through the willingness of firms to work at it.
4) Firm Strategy, Structure, and Rivalry: The conditions in the home-nation that either hinder or aid in the firm’s creation and sustaining of international competitiveness. Porter notes that no one managerial, ownership, or operational strategy is universally appropriate. It depends on the fit and flexibility of what works for that industry in that country at that time.
Porter’s emphasis on innovation as the source of competitiveness reflects an increased focus on the industry and product that we have seen in the past three decades. The acknowledgment that the nation is “more, not less, important” is to many eyes a welcome return to a positive role for government and even national-level private industry in encouraging international competitiveness. Including factor conditions as a cost component, demand conditions as a motivator of firm actions, and competitiveness all combine to include the elements of classical, factor proportions, product cycle, and imperfect competition theories in a pragmatic approach to the challenges that the global markets of the twenty-first century present to the firms of today.
Limitations of the Porter’s Diamond Theory
The existence of the four favorable conditions does not guarantee that an industry will develop in a given locale. Entrepreneurs may face favorable conditions for many different lines of business. In fact, comparative advantage theory holds that resource limitations may cause, companies in a country to avoid competing in some industries even though an absolute advantage may exist. For example, conditions in Switzerland would seem to have favored success if companies in that country had become players in the personal computer industry. However, Swiss companies preferred to protect their global positions in such product lines as watches and scientific instruments rather than to downsize those industries by moving their highly skilled people into a new industry.
A second limitation concerns the increased ability of .companies to attain market information, production factors, and supplies from abroad. Actually this complex issue could be broken into four separate considerations, as given below:
1) Observations of foreign or foreign plus domestic, rather than just domestic, demand conditions have spurred much of the recent growth in Asian exports. In fact, such Japanese companies as Uniden and Fujitech target their sales almost entirely to foreign markets.
2) Companies and countries are not dependent entirely on domestic factor conditions. For example, capital and managers are now internationally mobile.
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3) If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad because of advancements in transportation and the relaxation of import restrictions. In fact, many MNEs now assemble products with parts supplied from a variety of countries.
4) Companies react not only to domestic rivals but also to foreign-based rivals they compete with at home and abroad. Thus, the absence of any of the four conditions from the diamond domestically may not inhibit companies and industries from becoming globally competitive.
Professor John Dunning proposed the eclectic paradigm as a framework for determining the extent and pattern ' 0f the value-chain operations that companies own abroad. Dunning draws from various theoretical perspectives including the comparative advantage and the factor proportions, monopolistic advantage, and internalization advantage theories. The eclectic theory is the most widely cited and accepted theory of FDI currently. The eclectic theory of international production attempts to provide an overall framework for explaining why firms choose to engage in FDI rather than serve foreign markets through alternatives such as exporting, licensing, management contracts, joint ventures, or strategic alliances.
The eclectic paradigm specifies three conditions that determine whether or not a company will internationalize via FDI:
1) O-Ownership-Specific Advantages: To successfully enter and conduct business in a foreign market, the MNE must possess ownership-specific advantages (unique to the firm) relative to other firms already doing business in the market. These consist of the knowledge, skills, capabilities, processes, relationships, or physical assets held by the firm that allows it to compete effectively in the global marketplace. They amount to the firm’s competitive advantages. To ensure international success, the advantages must be substantial enough to offset the costs that the firm incurs in establishing and operating foreign operations. They also must be specific to the MNE that possesses them and not readily transferable to other firms. For example, proprietary technology, managerial skills, trademarks or brand names, economies of scale, and access to substantial financial resources. The more valuable the firm’s ownership-specific advantages, the more likely it is to internationalize via FDI.
2) L-Location-Specific Advantages: These refer to the comparative advantages that exist in individual foreign countries. Each country possesses a unique set of advantages from which companies can derive specific benefits. For example, natural resources, skilled labor, low-cost labor, and inexpensive capital. Sophisticated managers recognize and seek to benefit from the host country advantages. A location-specific advantage must be present for FDI to succeed. It must be profitable to the firm to locate abroad, i.e., to utilize its ownership-specific advantages in conjunction with atleast some location-specific advantages in the target country. Otherwise, the firm would use exporting to enter foreign markets.
3) I-Internalization Advantages: These are the advantages that the firm derives from internalizing foreign- based manufacturing, distribution, or other stages in its value chain. When profitable, the firm will transfer its ownership-specific advantages across national borders within its own
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organization, rather than dissipating them to independent, foreign entities. The FDI decision depends on which is the best option - internalization versus utilizing external partners — whether they are licensees, distributors, or suppliers. Internalization advantages include — the ability to control how the firm’s products are produced or marketed, the ability to control dissemination of the firm’s proprietary knowledge, and the ability to reduce buyer uncertainty about the value or products the firm offers.
Because of the names of these three types of advantages that a firm must have, the eclectic theory of international production is sometimes referred to as the OLI model. This theory provides an explanation for an international firm’s choice of its overseas production facilities. The firm must have both location and ownership advantages to invest in a foreign plant. It will invest where it is most profitable to internalize its monopolistic advantage. These investments can be proactive, being strategically anticipated and controlled in advance by the firm’s management team, or reactive, in response to the discovery of market imperfections:
3.2.8.3. Monopolistic Advantage Theory:The modem monopolistic advantage theory stems from Stephen Hymer’s dissertation in the 1960s, in which he demonstrated that foreign direct investment occurs largely in oligopolistic industries rather than in industries operating under near-perfect competition. This means that the firms in these industries must possess advantages not available to local firms in order to overcome liabilities associated with being a foreigner - such as lack of knowledge about local market conditions, increased cost of operating at a distance, 6r differences in culture, language, laws and regulations, or institutions - that cause a foreign company to be at a disadvantage against local firms. Hymer reasoned that the advantages must be economies of scale, superior technology, or superior knowledge in marketing, management, or finance. Foreign direct investment takes place because of these product and factor market imperfections, which enable the multinational enterprise to operate more profitably in foreign markets than can local competitors.
This theory suggests that firms that use FDI as an internationalization strategy tend to control certain resources and capabilities that give them a degree of monopoly power relative to foreign competitors. The advantages that arise from this monopoly power enable the MNE to operate foreign subsidiaries more profitably than the local firms that compete in those markets. A key assumption of the theory is that, to be successful, an MNE must possess monopolistic advantages over local firms in foreign markets. In addition, the firm must keep these advantages to itself by internalizing them. These advantages are specific to the MNE rather than to the location of its production, are owned by the MNE and not easily available to its competitors. For example, South African firm SAB Miller, the second largest beer brewer in the world, leverages a near monopoly in its home country, relying on extensive international business expertise, and offering a unique line of beers to customers around the world.
The most important monopolistic advantage is superior knowledge which includes intangible skills possessed by the MNE that provide a competitive advantage over local rivals in foreign markets. Superior, proprietary knowledge allows MNEs to create differentiated products that provide unique value to customers.
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3.2.8.4. Internalization Theory:This theory is an extension of the market imperfection theory. A firm has superior knowledge, but due to inefficiency in external markets, the firm may obtain a higher price for that knowledge by using tire knowledge itself rather than by selling it in the open market. By investing in foreign subsidiaries for activities such as supply, production, or distribution, rather than licensing, the company is able to send the knowledge across borders while maintaining it within the firm. The expected result is the firm’s ability to realize a superior return on the investment made to produce this knowledge, particularly as the knowledge is embodied in various products or services that are sold to customers.
Some scholars investigated the specific benefits that MNEs derive from FDI-based entry. For example, when Procter & Gamble entered Japan, management initially considered exporting and FDI. With exporting, P&G would have had to contract with an independent Japanese distributor to handle warehousing and marketing of soap, detergent, diapers, and the other products that P&G now sells in Japan. However, because of trade barriers imposed by the Japanese Government, the strong market power of local Japanese firms and the risk of losing control over its proprietary company knowledge, P&G chose instead to enter Japan via FDI. P&G established its own marketing subsidiary and, eventually, national headquarters in Tokyo. Such an arrangement provided various benefits that P&G would not have received had it entered Japan by contracting with Japanese distributors not owned by P&G.
This example reveals how MNEs internalize key business functions and assets within the corporate organization. Internalization theory explains the process by which firms acquire and retain one or more value- chain activities inside the firm, minimizing the disadvantages of dealing with external partners and allowing for greater control over foreign operations. It contrasts the costs and benefits of retaining key business activities within the firm against arms-length foreign entry strategies such as exporting and licensing, in which the firm contracts with external business partners to perform certain value-chain activities. By internalizing foreign- based value-chain activities it is the firm, rather that its products, that crosses international borders. For example, instead of procuring from foreign independent suppliers, the MNE internalizes the supplier function by acquiring or establishing its own facilities in the foreign market. Where one firm might contract with independent foreign distributors to market its products abroad, the MNE internalizes the marketing function by establishing or acquiring its own distribution subsidiary abroad. The MNE is ultimately a vehicle for bypassing the bottlenecks and costs of the international, inter-firm exchange of goods, materials, and workers. In this way, the MNE replaces business activities performed in external markets with business activities performed within its own internal market.
Knowledge is critical to the development, production, distribution, and sale of products and services. Because competitors can easily acquire and use a firm’s knowledge, firms .internalize their key knowledge by internationalizing via FDI instead of other modes such as exporting. FDI allows management to control and optimally use the firm’s proprietary knowledge in foreign markets.
3.2.9. MODES OF FOREIGN INVESTMENT:The modes of foreign investment are as follows:
Modes of Foreign Investment
Green field Investments
Licensing
Joint Ventures
Management Contracts
Franchising
Acquisition
Exporting
Strategic Alliances
Turnkey Contracts
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3.2.9.1. Licensing:Licensing used to be regarded as a 'second-rate method of entry into a foreign market. It is the most attractive entry method because of the nature of the market or because of the resources or strategy of the firm. Although licensing is a relatively eäsy förrti of entry, it iS controversial mainly because, overall, the transfer of technology is from the richer economies to the poorer nations that don’t have the resources to develop or buy their own technology, or whose markets are so small they won’t justify doing it. Most companies decide to go the licensing road because of the characteristics of the market itself. Some firms may look at the market and because of the difficulties of the other more conventional forms of entry may decide to pass it up altogether.
Benefits of Licensing for the Licensee
Licensing provides benefits to both parties. The licensor receives profits in addition to those generated from operations in domestic markets. There are various ways in which a license agreement can give the licensee the possibility of increasing revenues and profits and of enlarging market share:
1) There is often a rush to bring new products onto the market. A license agreement that gives access to technologies which are already established or readily available can make it possible for an enterprise to reach the market faster.
2) Small companies may not have the resources to conduct the research and development necessary to provide new or superior products. A license agreement can give an enterprise access to technical advances that would otherwise be difficult for if to obtain.
3) A license can also be necessary for the maintenance and development of a market position that is already well established but is threatened by a new design or new production methods. The costs
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entailed in following events and trends can be daunting and quick access to a new technology through a license agreement may be the best way to overcome this problem.
4) There may also be licensing-in opportunities which, when paired with the company’s current technology portfolio, can create new products, services and market opportunities.
Limitations of Licensing for the Licensee
The limitations of licensing for the license are as follows:
1) The licensee may have made a financial commitment for a technology that is not ‘ready’ to be commercially exploited or that must be modified to meet the licensee’s business needs.
2) An IP license may add a layer of expense to a product that is not supported by the market for that product. It is fine to add new technology, but only if it comes at a cost that the market will bear in terms of the price that can be charged. Multiple technologies added to a product can result in a technology-rich product that is too expensive to bring to market.
3) Licensing may create technology dependence on the supplier, who could choose to not renew a license agreement, to negotiate license agreements with competitors, to limit the markets in which you may use the licensed technology or to limit the acts of exploitation allowed under the licensing agreement
3.2.9.2. Management contractsUnder the management contract, the firm undertakes the management of a firm in the foreign market. The firm providing the management know-how many not has any equity stake in the enterprise being managed. In short, in a management contract the supplier brings together a package of skills that will provide an, integrated service to the client without incurring the risk and benefit of ownership.
Management contract could, sometimes, bring in additional benefits for the managing company. It may obtain the business of exporting or selling otherwise of the products of the managed company or supplying the inputs required by the managed company. Some Indian companies - Tata Tea, Harrisons Malayalam and AVT - have contracts to manage a number of plantations in Sri Lanka. Tata Tea also has a joint venture in Sri Lanka namely Estate Management Services Pvt. Ltd.
3.2.9.3. Joint Ventures:Joint venture is a venture that is jointly owned and operated by two or more firms. Many firms penetrate foreign markets by engaging in a joint venture with firms that reside in those markets. For example, Xerox Corp and Fuji Co. engaged in a joint venture that allowed Xerox Corp to penetrate the Japanese market.
Joint ventures tend to be relatively lower-risk operations because the risks are shared by individual partner. Each party to these ventures contributes capital, equity, or assets. Ownership of the joint venture need not be a 50-50 arrangement and, indeed, percentage of ownership ranges according to the proportionate amounts contributed by each party to the enterprise. Some countries stipulate the relative amount of ownership allowable to foreign firms in joint ventures.
Types of Joint Venture
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Joint ventures are common within industries and in various countries. But they are specially useful or entering international markets. From the point of view of Indian organizations, the following types of joint ventures are possible.
1) Between two firms in one industry,2) Between two firms across different industries,3) Between an Indian firm and a foreign company in India,4) Between an Indian firm and a foreign company in that foreign country, and5) Between an Indian firm and a foreign company in a third country.
Benefits of Joint Venture
Following are the benefits of joint ventures:
1) Provide companies with the opportunity to gain new capacity and expertise.2) Allow companies to enter related businesses or new geographic markets or gain new
technological knowledge.3) Access to greater resources, including specialized staff and technology.4) Sharing of risks with a venture partner.5) Joint ventures can be flexible. For example, a joint venture can have a limited life span and only
cover part of what you do, thus limiting both your commitment and the business’ exposure.6) In the era of divestiture and consolidation, JV’s offer a creative way for companies to exit from
non-core businesses.7) Companies can gradually separate a business from the rest of the organization and eventually,
sell it to the other parent company. Roughly 80% of all joint ventures end in a sale by one partner to the other.
Limitations of Joint Ventures
Following are the limitations of joint ventures:
1) It takes time and effort to build the right relationship and partnering with another business can be challenging. Problems are likely to arise if:
i. The objectives of the venture are not 100 per cent clear and communicated to everyone involved.
ii. There is an imbalance in levels of expertise, investment or assets brought into the venture by the different partners.
2) Different cultures and management styles result in poor integration and co-operation.3) The partners don’t provide enough leadership and support in the early stages.4) Success in a joint venture depends on thorough research and analysis of the objectives.
3.2.9.4. Greenfield Investment:A Greenfield Investment is the investment in a manufacturing, office, or other physical company-related structure or group of structures in an area where no previous facilities exist. The name comes from the idea of building a facility literally on a "green" field, such as farmland or a forest. Overtime the term has become more metaphoric.
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Greenfield Investing is usually offered as an alternative to another form of investment, such as mergers and acquisitions, joint ventures, or licensing agreements. Greenfield Investing is often mentioned in the context of Foreign Direct Investment.
A related term to Greenfield Investment which is becoming popular is Brownfield Investment, where a site previously used for a "dirty" business purpose, such as a steel mill or oil refinery, is cleaned up and used for a less polluting purpose, such as commercial office space or a residential area.
A form of foreign direct investment where a parent company starts a new venture in a foreign country by constructing new operational facilities from the ground up. In addition to building new facilities, most parent companies also create new long-term jobs in the foreign country by hiring new employees.
Developing countries often offer prospective companies tax-breaks, subsidies and other types of incentives to set up green field investments. Governments often see that losing corporate tax revenue is a small price to pay if jobs are created and knowledge and technology is gained to boost the country's human capital.
Benefits of Greenfield Investment
Following are the benefits of Greenfield investment:
1) Provides maximum design flexibility to meet project requirements,2) New facility will reduce required maintenance,3) Can be designed to meet current and future needs,4) Opportunity to improve corporate image,5) Suitable for either lease or own option.
Limitations of Greenfield Investment
Following are the limitations of Greenfield investment:
1) Some sites are not fully developed and have additional development costs such as headworks costs for sewer and water, '
2) Council approval time frames may be longer for new sites,3) High demand of industrial sites may mean that sites available have difficulties (slope, ground
conditions).
3.2.9.5. Acquisitions:Acquisitions is acquiring or purchasing an existing venture. It is one of the easy means of expanding a business by entering new markets or new product areas. An entrepreneur must be careful in structuring the payment so that he will not be financially overburdened. He must create a scope for phase wise payments so that the company generates funds to pay. An acquisition strategy is based upon the assumption that companies for potential acquisition will be available, but if the choice of companies is limited, the decision may be taken on the basis of expediency rather than suitability. The belief that acquisitions will be a time-saving alternative to waiting for organic growth to take effect may not prove to be true in practice. It can take a considerable amount of time to search and evaluate possible
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acquisition targets, engage in protracted negotiations and then integrate the acquired company into the existing organization structure.
Benefits of Acquisitions
Following are the benefits of acquisitions:
1) Buying an established business is always advantageous. If it is already profitable the entrepreneur needs to keep up the continuity.
2) Familiarly with line of activity, region, market will make it easier to take advantage of acquisition.
3) Existing distributors, dealers, traders can be made most use of due to additional quantum^output on account of acquisition.
4) The method of expansion costs lower than other methods.5) The knowledge, skills and expertise of existing employees will prove to be very beneficial to the
company.
Limitations of Acquisitions
Following are the limitations of acquisitions:
6) Many companies on sale are poor performers having outdated technology and low morale employees.
7) The location, equipments and layout factors cannot be changed and hence may be problematic.8) Often when owners change, some of the key employees leave the job thus creating void. This
could be mere, problematic in high-tech areas.9) Companies sell their old firms at inflated rates more due to land values than due to high
technology capabilities and pending orders.
3.2.9.6. Strategic Alliances:A Strategic Alliance is a formal relationship between two or ore parties to pursue a set of agreed upon goals or to meet a critical business need while remaining independent organizations.
Partners may provide ‘ the strategic alliance with resources such as, products, distribution channels, manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual property. The alliance is a co-operation or collaboration which aims for a synergy where each partner hopes that the benefits from the alliance will be greater than those from individual efforts. The alliance often involves technology transfer (access to knowledge and expertise), economic specialization, shared expenses and shared risk. Non-equity strategic alliances, equity strategic alliances, and joint ventures are the three basic types of strategic alliances.
Benefits of Strategic Alliance
The benefits of strategic alliance includes:
1) Allowing each partner to concentrate on activities that best match their capabilities.2) Learning from partners and developing competences that may be more widely exploited
elsewhere.
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3) Adequency a suitability of the resources and competencies of an organization for it to survive.
Limitations of Strategic Alliance
Following are the limitations of strategic alliance:
1) Implementing and managing a strategic alliance may be difficult because each alliance partner has a different way of operating.
2) Mistrust could occur, particularly when competitive or proprietary information is involved.3) The alliance partners could become more dependent on each other, making it difficult to
operate again as separate entities if required.
3.2.9.7. Exporting:Entrance into an export market frequently begins casually, with the placement of an order by a customer 4 overseas. At other times, an enterprise sees a market opportunity and actively decides to take its products or services abroad. A firm can be either a direct or an indirect exporter. As a direct exporter, it sees to all phases of the sale and> transmittal of the merchandise. In indirect exporting, the exporter hires the expertise of someone else to facilitate the exchange. This intermediary is, of course, happy to oblige for a fee. There are several types of intermediaries; manufacturers’ export agents, who sell the company’s product overseas; manufacturers’ representatives, who sell the products of a number of exporting firms in overseas markets; export commission agents, who act as buyers for overseas markets; export commission agents, who act as buyers for overseas customers and export merchants, who buy and sell on their own for a variety of markets.
Sales contacts within the foreign market are made through personal meetings, letters, cables, telephone calls or international trade fairs. Some of these trade expositions take unusual forms; e.g., in an attempt to promote the sale of U. S. products in Japanese markets, the Japanese government established a traveling trade show on a train.
Benefits of Exporting
The prime benefit of exporting is that it involves very little risk and low allocation of resources for the exporter, who is able to use domestic production toward foreign markets and thus increase sales and reduce inventories.
1) Increased Sales and Profits: Selling goods and services to a market, the company never had before, boost sales and increases revenues. Additional foreign sales over the long-term, once export development costs have been covered, increase overall profitability.
2) Enhance Domestic Competitiveness: Most companies become competitive in the domestic market before they venture in the international arena. Being competitive in the domestic market helps companies to acquire some strategies that can help them in the international arena.
3) Gain Global Market Shares: By going international, companies will participate in the global market and gain a piece of their share from the huge international marketplace.
4) Diversification: Selling to multiple markets allows companies to diversify their business and spread their risk. Companies will not be tied to the changes of the business cycle of domestic market or of one specific country.
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5) Lower per Unit Costs: Capturing an additional foreign market will usually expand production to meet foreign demand. Increased production can often lower per unit costs and lead to greater use of existing capacities.
6) Compensate for Seasonal Demands: Companies whose products or services are only used at certain seasons domestically may be able to sell their products or services in foreign markets during different seasons.
7) Create Potential for Company Expansion: Companies who venture into the exporting business usually have to have a presence or representation in the foreign market. This might require additional personnel and thus lead to expansion.
8) Sell Excess Production Capacity: Companies who have excess production for any reason can probably sell their products in a foreign market and not be forced to give deep discounts or even dispose of their excess production.
9) Gain New Knowledge and Experience: Going international can yield valuable ideas and information about new technologies, new marketing techniques and foreign competitors. The gains can help a company’s domestic as well as foreign businesses.
10) Expand Life Cycle of Product: Many products go through various cycles namely introduction, growth, maturity and declining stage that is the end of their usefulness in a specific market. Once the product reaches the final stage, maturity in a given market, the same product can be introduced in a different market where the product was never marketed before.
Limitations of Exporting
While the benefit of exporting by far outweigh the limitations, small and medium size enterprises, especially face some challenges when venturing in the international marketplace:
1) Extra Costs: Because it takes more time to develop extra markets and the pay back periods, are longer, the up-front costs for developing new promotional materials, allocating personnel to travel and other administrative costs associated to market the product can strain the meager financial resources of small size companies.
2) Product Modification: When exporting, companies may need to modify their products to meet foreign country’s safety and security codes and other import restrictions. At a minimum, modification is often necessary to satisfy the importing country’s labeling or packaging requirements.
3) Financial Risk: Collections of payments using the methods that are available (open-account, pre-payment, consignment, documentary collection and letter of credit) are not only more time-consuming than for domestic sales, but also more complicated. Thus, companies must carefully weigh the financial risk involved in doing international transactions.
4) Export Licenses and Documentation: Though the trend is towards less export licensing requirements, the fact that some companies have to obtain an export license to export their goods makes them less competitive. In many examples, the documentation required to export, is more involved, than for domestic sales.
5) Market Information: Finding information on foreign markets is unquestionably more difficult and time- consuming than finding information and analyzing domestic markets. In less developed countries, e.g., reliable information on business practices, market characteristics and cultural barriers may be unavailable.
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3.2.9.8. FranchisingFranchising refers to the methods of practicing and using another person’s philosophy of business. The franchisor grants the independent operator, the right to distribute its products, techniques and trademarks for a percentage of gross monthly sales and a royalty fee. Various tangibles and intangibles such as national or international advertising, training, and other support services are commonly made available by the franchisor. Agreements typically last from five to thirty years, with premature cancellations or terminations of most contracts bearing serious consequences for franchisees.
Benefits of Franchising
Following are the benefits of franchising:
1) The advantages accruing to the franchisor are increased revenues and expansion of its brand-name identification and market reach.
2) The franchisor gives you support - usually including training, help setting up the business, a manual telling you how to run the business and ongoing advice.
3) It usually has exclusive rights in the territory. The franchisor won’t sell any other franchises in the same region.
4) Financing the business may be easier. Banks are sometimes more likely to lend money to buy a franchise with a good reputation.
5) Risk is reduced and is shared by the franchisor.6) If one have an existing customer base they will not have to invest time looking to set one up.7) Relationships with suppliers have already been established.
Limitations of Franchising
Following are the limitations of franchising:
1) It is difficult to coping with the problems of assuring quality control and operating standards.2) Franchise contracts should be written carefully and provide recourse for the franchising firm,
should the Franchisee not comply with the terms of the agreement.3) Other difficulties with franchises come with their need to make slight adjustments or
adaptations in the standardized product or service. For example, some ingredients in restaurant franchises may need to be adapted to suit the tastes of the local clientele, which may differ from those of the original customers,
4) Costs may be higher than you expect. As well as the initial costs of buying the franchise, you pay continuing royalties and you may have to agree to buy products from the franchisor.
5) The franchise agreement usually includes restrictions on how you run the business. It might not be possible to make changes to suit local market.
6) The franchisor might go out of business or change the way they do things.7) Other franchisees could give the brand a bad reputation.8) Reduced risk means you might not generate large profits.
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3.2.9.9. Turnkey Contracts:Turnkey contracts are common in international business in the supply, erection and commissioning of plants, as in the case of oil refineries, steel mills, cement and fertilizer plants, etc.; construction projects as well as franchising agreements.
A turnkey project is a contract under which a firm agrees to fully design, construct and equip a manufacturing/business/service facility and turn the project over to the purchaser when it is ready for operation for remuneration. The form of remuneration includes:
1) A fixed price (firm plans to implement the project below this price)2) Payment on cost plus basis (i.e., total cost incurred plus profit)
This form of pricing allows the company to shift the risk of inflation/enhanced costs to the purchaser.
One of the major benefit of turnkey projects is the possibility for a company to establish a plant and earn profits in a foreign country especially in which foreign direct investment opportunities are limited and lack of expertise in a specific area exists.
Potential limitations of a turnkey project for a company include risk of revealing companies secrets to rivals, and takeover of their plant by the host country. By entering a market with a turnkey project proves, that a company has no long-term interest in the country which can become a disadvantage if the country proves to be the main market for the output of the exported process.
3.2.10. COSTS AND BENEFITS OF FDI:When direct investment flows from one country to another, it creates benefits both for the home country an e host country. At the same time, it involves some costs too. Thus, when a firm decides to make FDI, it takes into account the benefits and costs to be accrued to not only its home country but also to the host country. The host country perspective is no less significant because cooperation from the host government depends upon the benefits derived by the host country. In the present section, the benefits and costs of FDI are mentioned from the point of view of the home country as well as the host country. Since the host country perspective is more sensitive.
3.2.10.1. Benefits to Host Country: The benefits of host country are as follows:
1) Availability of Scarce Factors of Production: FDI helps attain a proper balance among different factors of production through the supply of scarce factors and fosters the pace of economic development. FDI brings in capital and supplements the domestic capital. This is a significant contribution where the domestic savings rate is too low to match the warranted rate of investment. It brings in scarce foreign exchange that activates the domestic sayings that would not have been put into investment in absence of the availability of foreign exchange.
2) Improvement in the Balance of Payments: FDI helps improve the balance of payments of the host country. The inflow of investment is credited to the capital account. At the same time, the current account improves because FDI helps either import substitution or export promotion. The host country is able to produce those items that were being imported earlier.
3) Building of Economic and Social Infrastructure: When the foreign investors invest in sectors such as the basic economic infrastructure, social infrastructure, financial markets and the
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marketing system, the host country is able to develop a support system that is necessary for rapid industrialization. Even if there is no investment in these sectors, the very presence of foreign investors in the host, country creates a multiplier effect and the support system develops automatically.
4) Fostering of Economic Linkages: Foreign firms have forward and backward linkages. They make demand for various inputs that in turn helps develop the input-supplying industries which is known as crowding-in effect. They employ labor force and so help raise the income of the employed people that in turn raises the demand and industrial production in the country.
5) Strengthening of Government Budget: The foreign» firms are a source of tax income for the government. They pay not only income tax, but tariff on their import as well. At the same time, they help reduce the governmental expenditure requirements through supplementing the government’s investment activities. All this eases the burden on the national budget.
3.2.10.2. Benefits to Home Country: The benefits of home country are as follows:
1) Creates New Employment: FDI benefits the home country with the creation of employment. It also assists in ensuring the workers are paid better salaries. This allows them to have an access to an improved lifestyle as well as more facilities. The manufacturing and production sector is greatly developed in the home country due to FDI investment. This increase in new industries is beneficial creating new employment.
2) New Technology: Foreign direct investment benefits the host country through introducing advanced skills and technology. New research will be conducted in that home country as the international organization looks for methods of enhancing its services. This leads to better technology that can be applied in other parts of the nation for further development j
3) Improves Export: The other vital advantage of FDI to the home country is that it enables these nations to enhance their export resources. Furthermore, research shows that nations who get FDI from other international organizations usually have lower interest rates. This means that their exported products are much cheaper and thus enhances export.
4) Increases Income: Income generated through taxation is increased by FDI investment. Actually, FDI plays an important role with regards to the increase in productivity of home countries. It improves the local economy and living standards, as well,
5) Improved Political Relations: FDI is a complement to foreign aid; it helps develop closer political ties between the home country and the host country which is beneficial for both the countries.
3.2.10.3. Cost to Host Country: The costs of host country are as follows:
1) Adverse Effects on Competition: The new foreign subsidiaries may grow to have more economic power and more attractively priced products than the host country companies.
2) Adverse Effects on Balance-of-Payments: If the foreign subsidiary imports large quantities - this contributes to the home country having a balance-of-payments deficit.
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3) Adverse Effects on Natural Resources; Raw materials are exploited keeping in view the interest of the home country that is sometimes detrimental to the interest of the host country.
4) No Employment Opportunities: As far as employment of locals is concerned, the MNCs normally show reluctance to train the local people. Technology being normally capital-intensive does not assure larger employment.
5) National Sovereignty and Autonomyi). Concern about key decisions can affect the host country economy.
ii). ‘Tear seems to be that if foreigners hold assets - they can somehow hold the country to ransom” «- depends on the amount:
a) A small amount may result in the foreign company being a bully.b) A large amount means a foreign company is vulnerable and needs to
cooperate.iii). Sometimes, the manufacturing processes followed by the foreign investors do not abide
by the pollution norms or by the norms regarding optimal use of the natural resources or the norms regarding location of industries.
3.2.10.4. Cost to Home Country: The costs of Home Country are as follows:
a) Undesired Outflow of Factors of Production: The cost accruing to the home country is only little. However, it cannot be denied that making of investment abroad takes away capital, skilled manpower and managerial professionals from the country. Sometimes the outflow of these factors of production is so large that it hampers the home country’s interest.
b) Possibility of Conflict with the Host-Country Government: The MNCs operate in different countries in order to maximize their overall profit. To this end, they adopt various techniques that may not be in the interest of the host country. This leads to a tussle between the host government and the home government which may have a deleterious effect on bilateral relations.
c) Home Country Trade: Home country trade position may deteriorate if the FDI results on low; cost goods being brought back to the home country - displacing home country goods.For examples, a Canadian textile company moving clothing operation to Latin America results in textile workers in Canada losing their jobs, Gildan T-shirts in Honduras, Nicaragua, Haiti and the Dominican Republic.
3.3. FOREIGN PORTFOLIO INVESTMENT3.3.1. MEANING OF FOREIGN PORTFOLIO
INVESTMENT:Foreign portfolio investment means a grouping of investment assets that focuses on securities from foreign markets rather than domestic ones. A foreign portfolio is designed to give the investor exposure to growth in emerging and international markets and provide diversification.
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Foreign portfolio investments allow investors to further diversify their assets by moving away from a domestic- only portfolio. This type of portfolio can carry increased risk due to potential economic instability stemming from emerging markets, but can also bring increased stability through investments in industrialized and more stable markets.
Due to the integration of global financial markets, many companies already have operations in more than one country. In other words, international portfolio investment means the purchase of stocks, bonds, and money market instruments by foreigners for the purpose of realizing a financial return which does not result in foreign management, ownership, or legal control. Portfolio investment is part of the capital account on the balance of payments statistics.
Some examples of portfolio investment are:
Purchase of shares in a foreign company.
Purchase of bonds issued by a foreign, government.
Acquisition of assets in a foreign country.
3.3.2. INTERNATIONALIZING THE DOMESTIC PORTFOLIO
The basic principles of traditional domestic portfolio theory to aid in the identification of the incremental changes introduced through, international diversification, the following theories show how diversifying the portfolio internationally alters the potential set of portfolios available to the inventor.
Optimal Domestic Portfolio
Classic portfolio theory assumes a typical investor is risk-averse. This means that an investor is willing to accept some risk but is not willing to bear unnecessary risk. The typical investor is, therefore, in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk.
Optimal Domestic Portfolio Construction
The domestic investor may choose among a set of individual securities in the domestic market. The near infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set shown in the following figure 3.3. The set of portfolios formed along the extreme left edge of the domestic portfolio opportunity set is termed the efficient frontier. It represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return. The portfolio with the minimum risk among all those possible the Minimum Risk Domestic Portfolio (MRDP).
Investor may choose a portfolio of assets enclosed by the domestic portfolio opportunity set. The Optimal domestic portfolio is found at DP, where the capital market line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is designated MRDP
Rf
RDP
DP
MRDP
DP
Expected risk of portfolio, P
Domestic portfolio opportunities set
Minimum Risk Domestic Portfolio (MRDP)
Capital Market line (domestic)
Optimal domestic portfolio, DP
Expected return of portfolio, RP
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The individual investor will search out the optimal Domestic Portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. He or she begins with the risk-free asset with return of Rf (and zero expected risk) and moves out along the security market line until reaching portfolio DP. This portfolio is defined as the optimal domestic portfolio because it proves out info risky space at the steepest slope - maximizing the slope of expected portfolio return over expected risk - while still touching the opportunity set of domestic portfolios. This line is called the capital market line and portfolio theory assumes an investor who can borrow and invest at the risk-free rate can move to any point along this line.
Note that the optimal domestic portfolio is not the portfolio of Minimum Risk (MRDP). A line stretching from the risk-free asset to the minimum risk domestic portfolio would have a lower slope than the capital market line and the investor would not be receiving as great an expected return (vertical distance) per unit of expected risk (horizontal distance) as that found at DP.
3.3.3. INTERNATIONAL PORTFOLIO DIVERSIFICATION
The following figure shows the impact of allowing the investor to choose among an internationally diversified set of potential portfolios. The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set. At any point on the' efficient frontier of the internationally diversified portfolio opportunity set, the investor can find a portfolio of lower expected risk for each level of expected return.
Rf
RDP
DP
DP
Expected risk of portfolio, P
Domestic portfolio
opportunities set
Internationally diversified portfolio opportunity set
Expected return of portfolio, RP
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It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.
Internationally Diversified Portfolio Opportunity Set
Addition of internationally diversified portfolios to the total opportunity set available to the investor shifts the total portfolio opportunity set left, providing lower expected risk portfolios for each level of expected portfolio return
For example, Sony Corporation is listed on the Tokyo Stock Exchange. Sony’s share price derives its value from both the individual business results of the firm and the market in which it trades. If either or both are not perfectly positively correlated to the securities and markets available to a U.S. based investor, then that investor would observe the opportunity set shift shown in above figure.
Optimal International Portfolio
Rf
RDP
DP
DP
Expected risk of portfolio, P
Optimal international portfolio
Internationally diversified portfolio opportunity set
Expected return of portfolio, RP
RIP
IP
IP
Domestic portfolio opportunities set
Capital Market line (domestic)
Capital Market line (international)
Risk reduction of optimal portfolio
Increased return of optimal portfolio
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Gains from International Portfolio Diversification
The investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. The optimal international portfolio, IP, is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of R| to a point of tangency along the internationally diversified efficient frontier.
The benefits of international diversification are now obvious. The investor’s optimal portfolio IP possesses both higher expected portfolio return (R IP > RDP) and lower expected portfolio risk ( σIP<σDP ) than the purely domestic optimal portfolio. The optimal international portfolio is superior to the optimal domestic portfolio.
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3.3.3.1. Rationale for International Portfolio Diversification
The systematic risk of a domestically diversified portfolio of securities arises from the dependence of all industries in the economy on a common set of macroeconomic factors and uncertainties, e.g., weather, political events, economic policies, cultural influences, etc. This dependence generates positive correlation between security returns of a domestically diversified portfolio. Thus, purely domestic diversification puts a limit on risk reduction.
It is in this context that an internationally diversified portfolio becomes attractive to investors. A portfolio that incudes securities from different countries would be able to achieve further risk reduction than a domestic portfolio. This is possible because different countries may have different business and economic environments on account of diverse economic policies and programs followed in different countries
As a result, there may not be much positive correlation between security returns from different countries. As securities from different countries are added to the investment portfolio of an investor, the risk of the portfolio gets reduced further because the returns from such foreign securities do not have much positive correlation with those from the domestic securities in the portfolio.
Thus, diversification of a portfolio across national boundaries becomes an effective strategy for risk reduction in investment. This is the primary rationale for international portfolio diversification.
3.3.3.2. Barriers to International Portfolio Investment
It is an established fact that the international diversification of portfolio is gainful. But there are also some barriers that mar an optimal international diversification of portfolio. These problems are broadly:
1) Unfavorable Exchange Rate Movement: An investor cannot ignore the possibility of exchange rate changes. In a floating-rate regime, the exchange rate changes are a normal phenomenon. A change influences the value of the foreign portfolio as well as the earnings therefrom both directly and indirectly. Suppose an American investor invests in Indian securities. If the Indian rupee depreciates, the value of Indian securities in terms of U.S. dollars will be lower. At the same time, the amount of earning too shall be lower in terms of U.S. dollars. This may be said to be a direct impact of the exchange rate changes. Exchange rate changes have an indirect impact on international portfolio too. Since the foreign exchange market and the securities market are closely interlinked, any depreciation of domestic currency, the rupee in our example, will have an adverse effect on the security market index. The value of the securities in which the American investor has invested will be lower in rupee terms also.
2) Frictions in International Financial Market: There are market frictions manifesting in Governmental controls varying tax laws and explicit and implicit transaction costs. Governments often try to administer international financial flows through different forms of control mechanisms, such as multiple exchange rates, taxes on international flows, and restrictions on the outflow of funds. If such controls persist, foreign investment inflow is hampered despite ample returns/low risk.
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Again varying tax laws and varying tax rates come in the way of international investment. In many countries, capital gains, dividend, and interest income are taxed and there is tax also on financial transactions. If the rates’ are high, post-tax returns are obviously low. There are, of course, treaties to help in avoiding double taxation, even then taxes limit the scope of international portfolio investment.Yet again, there are varieties of implicit and explicit transaction costs, such as trading commission/fees and bid-ask spreads, etc. In developed countries, transaction costs are often less cumbersome. But in emerging market economies, they figure large. Moreover, transaction cost per unit falls with growing size of transaction, but the small investors do not get this advantage.
3) Manipulation of Security Prices: It is true that in a perfectly competitive financial market, no investor can influence the market price of securities. But in the real world, it is the Government and also the big brokers that influence the security prices. The Government influences them through its monetary and fiscal policies. It can change interest rates, tax rates, etc. It can change the regulatory provisions. The manipulation is often large when the public sector financial institutions and banks hold big chunk of the securities traded on the stock exchange. In such cases, the asset portfolio lacks the desired liquidity with the result that the foreign portfolio investment becomes a costly and difficult proposition.
4) Unequal Access to Information: It is the wide cross-cultural differences that inhibit international portfolio investment. Accounting practices and the disclosure system vary among countries. The language varies from one country to the other. As a result, it is difficult for the international investors to collect information. In absence of desired information, It is difficult for them to act rationally.
3.3.3.3. Home Country BiasHome country bias is a term used to describe investment behavior whereby investors display a tendency to hold a large percentage of their assets in investments within their borders. This bias may have a positive net effect during periods when their home country is growing faster than foreign competitors and/or their currency appreciating relative to other currencies. However, this bias may lead to missed opportunities if foreign competitors are gaining world market share due to faster economic growth and/or their currencies are appreciating versus the home currency.
One would expect that most investors, particularly institutional« Und professional investors, .would be aware of the opportunities offered by international investing. Yet in practice, investor portfolios notoriously overweight home-country stocks compared to a neutral indexing strategy and underweight, or even completely ignore, foreign equities. This has come to be known as the home-country bias. Despite a continuous increase in cross- border investing, home-country bias still dominates investor portfolios.
Many studies have demonstrated the gain from international diversification. However, recent research has indicated that investors seem to greatly favor domestic assets and invest much less in foreign assess than one would expect given the expected gains from diversification.
The home bias enigma is the most puzzling investor behavior anomaly uncovered lately. It appears that investors under-diversify. Despite the clear theoretical and empirical demonstrations that diversification
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can improve the risk-return trade-offs of their portfolios, investors impose restrictions on diversification that is do not diversify enough. Individual and professional investors prefer to hold, and tilt their portfolio weights towards, stocks of companies that are familiar and (geographically) close to them.
The home bias was first detected in international finance, where it is referred to as the home country bias. Home-country bias, or simply home bias, usually refers to a situation in which the proportion of foreign equities held by domestic investors in their portfolios is too small relative to the predictions of standard portfolio theory. The extent to which equity portfolios are concentrated in equities of the investor's domestic market is a notable feature of international portfolio investment and has remained an important yet unresolved empirical puzzle in financial economics since the 1970s. Since portfolio, theory is the foundation of asset pricing theory, the empirical evidence that investors may not optimize along objective risk-return tradeoffs as portfolio theory predicts has important implications for our understanding of the way security prices are set.
Why do investors seem to have this bias in favor of securities of their home country? There are several possible reasons - taxes, transaction costs, or something else that is missing from the standard model of international investment. These reasons are explained below:
Taxes: If home bias is due to taxes, then the tax on foreign securities would have to be high enough to offset the higher return (or lower risk) expected from these securities. However, taxes paid to foreign governments can usually be credited against domestic taxes. Even if |here is some net increase in the tax paid op foreign investment, it is unlikely that this increase could be high enough to discourage foreign investment to the extent observed.
Transaction Costs: The cost associated with buying and selling foreign Securities includes explicit monetary costs, like fees, commissions, and bid-ask spreads, and implicit costs such as differences in regulations protecting investors, language differences, and costs of obtaining information about foreign investment opportunities. Familiarity with domestic assets and lower explicit costs of trading at home may lead to home .bias.
One possibility is that the gains from international diversification have been overstated. If countries tend to specialize in the production of certain goods and services and trade with the rest of the world for other goods and services, it is possible to imagine a situation where incomes fluctuate less than one might think based on fluctuations in domestic production. As output fluctuates for certain industries, relative prices change and this relative price change helps to smooth out income fluctuations. For example, if the Philippines specialize in pineapple production and bad weather reduces the harvest, pineapple prices rise due to the reduction in supply. This price increase helps to cushion the fall in income related to the poor harvest. In this manner, relative price changes may serve as a natural hedge against output fluctuations, so that there is less income variability to be reduced through diversification.
The desire by individual or institutional investors to direct foreign portfolio investment to a specific country is influenced by the following factors:
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1) Tax Rates on Interest or Dividends: Investors normally prefer to invest in a country where the taxes on interest or dividend income from investments are relatively low. Investors assess their potential after-tax earnings from investments in foreign securities.
2) Interest Rates: Portfolio investment can also be affected by interest rates. Money tends to flow to countries with high interest rates, as long as the local currencies are not expected to weaken.
3) Exchange Rates: When investors invest in a security in a foreign country, their return is affected by:
a. The change in the value of the security, andb. The change in the value of the currency in which the security is denominated.
If a country’s home currency is expected to strengthen, foreign investors may be willing to invest in the country’s securities to benefit from the currency movement.
Conversely, if a country’s home currency is expected to weaken, foreign investors may decide to purchase securities in other countries. In a period such as 2006, U.S. investors that invested in foreign securities benefited from the change in exchange rates. Since the foreign currencies strengthened against the dollar over time, the foreign securities were ultimately converted to more dollars when they were sold at the end of the year.
3.3.5. MODES OF FOREIGN PORTFOLIO INVESTMENT
There are different modes of foreign portfolio investment. An investor has to find-out which one of them is more suitable. Some of the common modes are:
1) Buying foreign securities or depository receipts directly from the domestic stock exchange if such securities are listed there;
i). Portfolio Equity: This is defined as investment which is made for the purpose of securing income or capital gains growth rather than to gain control of an enterprise. Such investments would normally be held in a range of companies with the aim of diversifying and reducing risk.
ii). Portfolio Bonds: These are similar to portfolio equity, in that the aim is to secure a financial return rather to gain control of an enterprise and that investors would normally hold bonds in a range of companies. Like portfolio equity they are bought and sold on a secondary market. The difference is that they are a loan rather than a share in the company. Bond holders thus receive a predetermined rate of interest rather than a dividend payment which depends on the profit performance of the company.
2) Approaching International Mutual Funds: Alternatively, an investor buys the shares of an internationally diversified mutual fund. There are many open-ended mutual funds that trade in international securities on behalf of the individual investor. They prefer liquidity and try to allocate portfolio in proportion to the market capitalization of the more important stock exchanges. The mutual funds are normally no-load funds, but some of them charge upfront fees.
3) Approaching Closed-End Country Funds: The closed-ended funds are different from the open-ended funds in that the former make investment initially in international securities and issue shares against the portfolio. They try to avoid any change in their investment portfolio
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depending upon the changes in the response of the investors. Such closed-ended funds experienced a hey-day in 1980s with the setting-up of Korea Fund. Now they are popular.
4) Buying Directly The Securities Of Domestic Companies Having Global Operation: An investor buys shares of domestic company that operates internationally. It is, in fact, indirect way of participating in the global economy. In this case, the investor does not have ample scope for reaping diversification benefits insofar as the systematic risk cannot be reduced to that extent.
3.3.6. ADVANTAGES OF FOREIGN PORTFOLIO INVESTMENT
Economists suggest that the foreign portfolio investment (FPI) can benefit the real sector of an economy in the following ways:
1) The inflow of FPI can provide a developing country non-debt creating source of foreign investment. The developing countries are capital scarce. The advent of portfolio investment can supplement domestic saving for improving the investment rate. By providing foreign exchange to the developing countries, FPI also reduces the pressure of foreign exchange gap for the LDCs, thus making imports of necessary investment goods easy for them.
2) It is suggested by mainstream economists that increased inflow of foreign capital increases the allocative efficiency of capital in a country. According to this view, FPI, like FDI, can induce financial resources to flow from capital-abundant countries, where expected returns are low, to capital-scarce countries, where expected returns are high. The flow of resources into the capital-scarce countries reduces their cost of capital, increases investment, and raises output. However, according to another view, portfolio investment does not result in a more efficient allocation of capital, because international capitalflows have little or no connection to real economic activity. Consequently portfolio investment has no effect on investment, output, or any other real variable with non-trivial welfare implications.
3) The most important way FPI affects the economy is through its various linkage effects via the domestic capital market. According to the mainstream view, one of the most important benefits from FPI is that it gives an upward thrust to the domestic stock market prices. This has an impact on the price-earning ratios of the firms. A higher P/E ratio leads to a lower cost of finance, which in turn can lead to a higher amount of investment. The lower cost of capital and a booming share market can encourage new equity issues. A higher premium in the new issues will be the inducing factor here. However, it must be clarified that equity investment may not always lead to an increase in real investment in the private sector. This is simply because most stock purchases are on the secondary market rather than the purchase of newly issued shares.
4) FPI also has the virtue of stimulating the development of the domestic stock market. The catalyst for this development is competition from foreign financial institutions. This competition necessitates the importation of more sophisticated financial technology, adaptation of the technology to local environment, and greater investment in information processing and financial services.
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3.3.7. DISADVANTAGES OF FOREIGN PORTFOLIO INVESTMENT
It is an established fact that the international diversification of portfolio is gainful. But there are also some limitations that mar an optimal international diversification of portfolio. These limitations are as follows:
1) Unfavorable Exchange Rate Movement: An investor cannot ignore the possibility of exchange rate changes. In a floating-rate regime, the exchange rate changes are a normal phenomenon. A change influences the value of the foreign portfolio as well as the earnings therefrom both directly and indirectly. Suppose an American investor invests in Indian securities. If the Indian rupee depreciates, the value of Indian securities in terms of U.S. dollars will be lower. At the same time, the amount of earning too shall be lower in terms of U.S. dollars. This may be said to be a direct impact of the exchange rate changes. Exchange rate changes have an indirect impact on international portfolio too. Since the foreign exchange market and the securities market are closely interlinked, any depreciation of domestic currency, the rupee in our example, will have an adverse effect on the security market index. The value of the securities in which the American investor has invested will be lower in rupee terms also.
2) Frictions in International Financial Market: There are market frictions manifesting in Governmental controls, varying tax laws and explicit and implicit transaction costs. Governments often try to administer international financial flows through different forms of control mechanisms, such as multiple exchange rates, taxes on international flows, and restrictions on the outflow of funds. If such controls persist, foreign investment inflow is hampered despite ample returns/low risk.Again, varying tax laws and varying tax rates come in the way of international investment. In many countries, capital gains, dividend, and interest income are taxed and there is tax also on financial transactions. If the rates are high, post-tax returns are obviously low. There are, of course, treaties to help in avoiding double taxation, even then taxes limit the scope of international portfolio investment. Yet again, there are varieties of implicit and explicit transaction costs, such as trading commission/fees and bid-ask spreads, etc. In developed countries, transaction costs are often less cumbersome. But in emerging market economies, they figure large. Moreover, transaction cost per unit falls with growing size of transaction, but the small investors do not get this advantage.
3) Manipulation of Security Prices: It is true that in a perfectly competitive financial market, no investor can influence the market price of securities. But in the real world, it is the Government and also the big brokers that influence the security prices. The Government influences them through its monetary and fiscal policies. It can change interest rates, tax rates, etc. It can change the regulatory provisions. The manipulation is often large when the public sector financial institutions and banks hold big chunk of the securities traded on the stock exchange. In such cases, the asset portfolio lacks the desired liquidity with the result that the foreign portfolio investment becomes a costly and difficult proposition.
4) Unequal Access to Information: It is the wide cross-cultural differences that inhibit international portfolio investment. Accounting practices and the disclosure system vary among countries. The language varies from one country to the other. As a result, it is difficult for the international
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investors to collect information. In absence of desired information, it is difficult for them to act rationally.
3.4. INTERNATIONAL CAPITAL BUDGETING3.4.1. CONCEPT OF INTERNATIONAL CAPITAL
BUDGETING:Capital budgeting for multinational firms uses the same framework as domestic capital budgeting. However, multinational firms engaged in evaluating foreign projects face a number of complexities, many of which are not there in the domestic capital budgeting process.
International capital budgeting is more complicated than domestic capital budgeting because MNCs are typically large and capital intensive, and because the process involves a larger number of parameters and decision variables. In general, international capital budgeting involves a consideration of more risk than domestic capital budgeting. But like domestic capital budgeting, international capital budgeting involves the estimation of some measures or criteria that indicate the feasibility or otherwise of a project (a capital budgeting evaluation measure) such as the Net Present Value (NPV). However, certain factors that are not considered in domestic capital budgeting should be taken into account in international capital budgeting because of the special nature of FDI projects.
The estimation of NPV and similar criteria requires:
1) The identification of the relevant expected cashflows to be used for the analysis of the proposed project and
2) The determination of the proper discount rate for finding the present value of the cashflows.
International capital budgeting involves substantial spending (capital investment) in projects that are located in foreign (host) countries, rather than in the home country of the MNC. Foreign projects differ from purely domestic project with respect to a number of factors - the foreign currency dimension, different economic indicators (such as inflation) in different countries, and different risk characteristics with which the MNC is not as familiar with as those pertaining to domestic projects. All these differences lead to a higher level of risk in international capital budgeting than in domestic capital budgeting.
3.4.2. FACTORS AFFECTING INTERNATIONAL CAPITAL BUDGETING
The factors affecting international capital budgeting are as follows:
1) Blocked Funds: If funds are blocked or otherwise restricted can be utilized in a foreign investment, the capital cost to the investor may be below the local project construction costs. From the investor’s perspective, there is a gain from activated funds equal to the difference between the face value of those funds and the present value of funds if the next best thing is done with them. This gain should be deducted from the capital cost of the project to find the cost from the investor’s perspective
2) Amenities and Concessions Granted by Host Countries: While governments do offer special financial aid or other kinds of help for certain domestic projects, it is very common for foreign investments to carry some sort of assistance. This may come in the form of low-cost land,
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income-tax holidays for a stated number of years, exemption from or reduction in custom duties on imported parts or raw materials (permanent or temporary), exemption from, or preferential treatment of, tax withheld on net income, concessionary loans (for initial investment and/or working capital purposes), subsidized utility rates, and so on. Most of these benefits require no special interest in the capital budgeting exercise, because they are, or should be, already reflected in capital costs. But concessionary lending is problematic since such financing will replace financing by the parent or from other higher interest sources. However, with the APV technique, we can add a separate term to include the subsidy. This is particularly important, since the special concessionary loan will be available to the corporation but not directly to the shareholders. This will make the appropriate cost of capital for foreign investment projects differ from that for the domestic projects, which is what happens in segmented capital markets.
3) Differing Rates of National Inflation: Long-term inflation rates - Differing rates of national inflation and their potential effect on competitiveness most be considered. Inflation will have the following effects on the value of the project:
i). It will impact the local operating cashflows both in terms of the prices of inputs and outputs, and also in terms of the sales volume depending on the price elasticity of the product.
ii). It will impact the parent’s cashflow by affecting the foreign exchange rates, andiii). It will affect the real cost of financing choices between foreign and domestic sources of
capital.4) Political Risk Involved in Foreign Investment: Political Risk - This is another factor that can
significantly impact the viability and profitability of foreign projects. Whether it be through democratic elections or as a result of sudden developments such as revolutions or military coups, changes in a country’s government can impact the attitude towards foreign investors and investments. This can affect the future cashflows of a project in that country in a variety of ways. Political developments may also affect the life and the terminal value of foreign investments.
5) Exchange Rate Fluctuations: Foreign Currency Fluctuations - Another added complexity in multinational capital budgeting is the significant effect that fluctuating exchange rates can have on the prospective cashflows generated by the investment. From the parent’s perspective, future cashflows abroad have value only in terms of the exchange rate at the date of repatriation. In conducting the analysis, it is necessary to forecast future exchange rates and to conduct sensitivity analysis of the project’s viability under various exchange rate scenarios.
6) Subsidized Financing: In order to attract foreign investments in key sectors, the governments of developing economies generally provide support in the form of subsidy. Likewise, international agencies entrusted with the responsibility of promoting cross-border trade sometimes offer financing at below- K market rates. The value of the subsidized loan should be added to that of the project while making the investment decision if the subsidized financing is inseparable from the project. But if subsidized financing B|s separable from a project, the additional value from the subsidized financing should not be allocated to the r project. In such a case, the manager’s decision is that so long as the subsidized loan is unconditional, it should be accepted. If the MNC can use the proceeds of subsidized financing at a higher rate in a comparable risk investment, it will lead to positive NPV to the firm.
7) Lost Exports: Another factor affecting the international capital budgeting is the issue of lost exports arising out of engaging in a project abroad. Profits from lost exports represent a
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reduction from the cashflows generated by foreign project for each year of its duration. This downward adjustment in cashflows may be total, partial or nil depending upon whether the project will replace projected exports' or none of them.
8) International Diversification Benefits: Dispersal of investment in a number of countries is likely to produce diversification benefits to the parent company’s shareholders. However, it would be difficult to quantify such benefits as can be allocated to a particular project.Generally, such non-quantifiable variables are ignored in capital budgeting decision. However, in case of a marginal project or a project which is not acceptable on its merits, this factor may be taken care of. Sometimes, a marginal project may be found worthwhile when its beneficial diversification effect on the overall pattern of cashflow generation by the MNC is taken into consideration.
9) Host Government Incentives: If the host government offers incentives, they should be included in the capital budgeting decisions. For example, if the host government offers tax incentives or provides loans at subsidized rates, the amount of gain on this account should be added to the operating cash inflow.
10) Difficulty in Estimating Terminal Value of Foreign Projects: Terminal values - While terminal values of long-term projects are difficult to estimate even in the domestic context, they become far more difficult in the multinational context due to the added complexity from some of the factors discussed above. An added dimension is that potential acquirers may have widely divergent perspectives on their value of acquiring the terminal assets. This is particularly relevant the assets are located in a country that is economically segmented due to a host of restrictions on cross-border flow of physical or financial assets.
3.4.3. EVALUATION OF PROJECTOnce a firm has compiled a list of prospective investments, it uses capital budgeting techniques to select from among them that combination of projects that maximizes the firm’s value to shareholders. The theoretical framework involved in evaluation of domestic projects is the same as for foreign projects and various considerations influencing choice of a project within the country are the, same as those for projects overseas. However, there are a host of factors which are unique to foreign investments that make cross-border investment decisions complicated.
The basic steps involved in evaluation of a project are:
1) Determine net investment outlay;2) Estimate net cashflows to be derived from the project over time, including an estimate of
salvage value;3) Identify the appropriate discount rate for determining the present value of the expected
cashflows;4) Apply NPV of IRR techniques to determine the acceptability or priority ranking of potential
projects.
This selection requires a set of rules and decision criteria that enables manager’s to, determine, given an investment opportunity, whether to accept or reject it. It is generally agreed that the criterion of net present value is the most appropriate one to use since its consistent application will lead the company to select the same investments the shareholders would make themselves, if they had the opportunity.
Approaches to project Evaluation
Discounted Cash Flow Analysis (DCF) Adjusted Present Value
Approaches (APV)
Net Present Value
Internal Rate of Return
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3.4.4. EVALUATION OF OVERSEAS INVESTMENT PROPOSAL
The fundamental goal of the financial manager is to maximize shareholders’ wealth. Shareholders’ wealth is maximized when the firm, out of a list of prospective investments, selects a combination of those projects that maximize the company’s value to its shareholders. This selection process requires the financial manager to discount the project cash flows at the firm’s weighted average cost of capital, or the projects’ required rate of return, to determine the net present value. Alternatively, the internal rate of return that equates project cash flows to the cost of the project is calculated, There are several methods through which the projects can be evaluated in capital budgeting like, payback period, internal rate of return, profitability index but finance manager^ generally believe that the criteria of net present value is the most appropriate in capital budgeting since it will help the company to Select only those investments which maximize the wealth, of the shareholders.
The methods of capital budgeting is as follows:
3.4.4.1. Evaluation of Overseas Investment Proposal Using Discounted Cash Flow Analysis (DCF)
Discounted cash; flow technique involves the use of the time value of money principle to project evaluation. The two most widely used criteria of the discounted cash flow technique are the net present value (NPV) and the internal rate of return (IRR). Both the techniques discount the project’s cash flow at an appropriate discount rate. The results are then used to evaluate the projects based on the acceptance/ rejection criteria developed by management,
1) Net Present Value (NPV): NPV is the most popular method and is defined as the present value of future cash flows discounted at an appropriate rate minus the initial net cash outlay for the projects. The discount rate used here is known as the cost of capital. The decision criterion is to accept projects with a positive NPV and reject projects which have a negative NPV.
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The NPV can be defined as follows:
NPV=−I 0+∑t=1
n CF t(1+K )t
Where
I0 = Initial cash investment
CFt = Expected after-tax cash flows in year t.
K = Weighted average cost of capital
n = Life span of the project
The NPV of a project is the present value of all cash inflows, including those at the end of the project s life, minus the present value of all cash outflows.
The decision criteria is to accept a project if NPV≥0 and to reject if NPV<0
For example, to set the stage, let us assume that you are trying to decide whether to undertake one of two projects. Project A involves buying expensive machinery that produces a better product at a lower cost. The machines for project A cost $1,000 and, if purchased, your anticipate that the project with produce cash flows of $500 per year for the next five years. Project B’s machines are cheaper, costing $800, but they produce smaller annual cash flows of $420 per year for the next five years. We will assume that the correct discount rate is 12%.
Suppose we apply the NPV criterion to project A and B:
YearTwo Projects
Project A Project B
0 -1,000 -800
1 50Q 420
2 500 420
3 500 420
4 500 420
5 500 420
NPV 802.39 714.01
Discount rate-12%
Both projects are worthwhile, since each has a positive NPV. If we have to choose between the projects, then project A is preferred to project B because it has the higher NPV.
Example 1; A project involves initial investment for $5,000,000. The net cash inflow during the first, second, and the third year is expected respectively $3,000,000, $3,500,000 and $2,000,000. At the end
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of fee third year, the scrap value is indicated at $ 1,000,000. The risk-adjusted discount rate is 10 per cent. Calculate NPV.
Solution:
¿ t 1+t 2+t 3−I 0
¿ 3,000,0001.10
+ 3,500,0001.102 + 2,000,000+1,000,000
1.103 −5,000,000=$2,873,778
Project would be accepted because NPV is positive.
2) Internal Rate of Return (IRR): IRR is calculated by solving for r in the following equation.
∑t=1
n CFt(1+r)t
−I0=0
Where, r is the internal rate of return of the project.
The IRR method finds the discount rate which equates the present value of the cash flows generated by the project with the initial investment or the rate which would equate the present value of all cash flows to zero.
To illustrate this technique, the study assumes a firm is considering investing in a project that has the following cash flows:
Year(t) Expected After-Tax Net Cash flows, C.F($)
0 (5,000)
1 800
2 900
3 1,500
4 1,200
5 3,200
CF = $(5,000) represents the net cost, or initial investment, that is required to purchase the asset - the parentheses indicate that the cashflow is negative.
The IRR for above project is:
NPV=−$5,000+ $ 8001+ IRR1 +
$ 9001+ IRR1 +
$1,5001+ IRR1 +
$1,2001+ IRR1 +
$3,2001+ IRR1
IRR=12.5%
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A project is acceptable using IRR if its IRR is greater than the firm’s required rate of return - i.e., IRR > r. Remember that the IRR represents the rate of return the firm will earn if the project is purchased. So, simply stated, the project must earn a return that is greater than the cost of the funds used to purchase it. In the example, IRR = 12.5%, which is greater than r = 12%, so the project is acceptable.
3.4.4.2. Evaluation of Overseas Investment Proposal Using Adjusted Present Value Model (APV)
THE APV model is a value additivity approach to-capital budgeting, i.e,, each cash flow as a source of value is considered individually. Also, in the APV approach lach bash flow is discounted at a rate of discount consistent with the risk inherent in that cash flow. In equation from the APV approach can be written as:
APV=I0+∑t=1
n X t¿¿¿ ¿
Where the term I0 = Present value of investment outlay
X t¿¿¿
= Present value of operating cash flows
T t(1+id)
t = Present value of interest tax shields
St(1+id)
t = Present value of interest subsidies
The various symbols denote,
Tt = Tax savings in year t due to financial mix adopted
St = Before-tax value of interest subsidies (on the home currency) in year t due to project specific financing
Id = Before-tax cost of dollar debt (home currency)
Example 2: A project costing $50 million is expected to generate after-tax cash flows bf $lß million a year forever. Risk-free rate is 3%, asset beta is 1.5, required return on market is 12%, cost of debt is 8%, annual interest costs related to project are $2 million and tax rate is 40%. Calculate the adjusted present value of the project.
Solution:
Adjusted Present Value = Present Value of Cash Flows + Present Value of Tax Savings
We need to find ungeared cost of equity which is 3% + 1.5*(12% - 3%) = 16.5%. Using this rate the present value of cash flows = $10 million/0.165 = $60.61 million. Initial investment is $50 million no net
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present value of future cash flows using ungeared cost of equity is $10.61million ($60.61 million - $50 million).
Adjusted Present value = present value of cashflows + present value of tax savings
= $10.61 million + $10million = $20.61 million
Decision Rule
The decision rule for adjusted present value is the same as net present value - accept positive APV projects and reject negative APV projects. The project discussed in the example has an APV of $20.61 which is positive hence the company should undertake the project.
3.4.5. PROBLEMS ASSOCIATED WITH INTERNATIONAL CAPITAL BUDGETING
International capital budgeting encounters a number of variables and factors that are unique for a foreign project and are considerably more complex than their domestic counterparts. These factors are:
1) Complexities of Regulatory Environment: The differences exist between the parent’s cash flow and the project’s cash flow because of tax laws and other regulatory environment. For parent, the cash flows to the B; parent are relevant because the shareholders expect higher rate of return. Therefore, it is necessary to make a distinction between parent’s cash flow from that of the project.
2) Complexities Due to Type of Financing: Parent’s cash flows depend on the form of financing that parent i adopts to finance the project (debt versus equity). Thus the parent’s cash flows cannot be separated from the financing decisions.
3) Difficulty in Recognizing the Exact Remittances: Remittances to the parent must be explicitly recognized. Because of differing tax laws, and political systems, differences in how financial markets and institutions function, the cash flows to the parent tend to vary. These aspects are also required to be considered while determining parent’s cash flows.
Problems Associated with International Capital
Budgeting
Difficulty in Anticipating Inflation Rates
Complexities of Regulatory Environment
Difficulty in Recognizing the Exact Remittances
Complexities Due to Type of Financing
Evaluation of Political Risk
Difficulty in Anticipating Changes in Exchange Rate
Subsidized Loans and cost of Capital
Segmented Capital Markets
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4) Difficulty in Anticipating Inflation Rates: Differing rate of inflation must also be anticipated for forecasting the real return and exchange rate forecasts. Inflation also changes the competitive position of the launched product/service. If the cash flows are in different currencies, the expected inflation rates are required to be forecasted for evaluating a project.
5) Difficulty in Anticipating Changes in Exchange Rate: Possibility of unanticipated changes in exchange rate changes must be considered because of possible direct effects on the value of local cash flows as well as on parent s cash flows. This unanticipated change will also have an indirect effect on the competitive position of the firm, thus affecting the long run cash flows.
6) Segmented Capital Markets: Since the project is being implemented in a different country, therefore the capital markets are segmented by space. Use of segmented capital markets may provide an opportunity or may involve higher costs. The financing aspect has to be carefully examined.
7) Subsidized Loans and Cost of Capital: Use of subsidized loans complicate both the capital structure and the ability to calculate weighted average cost of capital for discounting purposes.
8) Evaluation of Political Risk: For each project political risk must be evaluated. This is because the cash flows can be severely affected by the changes in political environment. The changes in the government would change the political philosophy thereby leading to new economic environment. Extreme form of risk is the ‘risk of expropriation’. In the case of expropriation, the project’s and the parent’s cash flows tend to change drastically because in this case the funds are blocked in the country of the project.
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3.5. MULTINATIONAL CORPORATION (MNC)3.5.1. MEANING AND DEFINITION OF MNCMultinational Corporation (MNC) or Transnational Corporation (TNC) is a corporation or enterprise that manages production or delivers services in more than one country.
A multinational corporation has been defined as follows:
“An enterprise which allocates company resources without regards to national frontiers, but is nationally based in terms of ownership and top management”.
“An enterprise which own or control production or service facilities outside the country in which they are based”.
Among the various other benchmarks sometimes it used to define ‘multinationality’ is that the company must:
1) Produce (rather than just distribute) abroad as well as in the headquarters-country.2) Operate in a certain minimum number of nations (six for example).3) Derive some minimum percentage of its income from foreign operations (e.g., 25 per cent)4) Have a certain minimum ratio of foreign to total number of employees, or of foreign total value
of assets.5) Possess a management team with geocentric orientations.6) Directly control foreign investments (as opposed simply to holding shares in foreign companies).
3.5.2. FINANCIAL GOALS OF MNCThe fundamental, objective of an MNC is to earn profit and this might clash with the host government’s objective of achieving better quality of life for its citizens. Such conflicts need to be resolved by the MNCs using their own initiative.
Following are the financial goals of MNCs and their subsidiaries:
1) Manufacture in those countries where it finds the greatest competitive advantage.2) Buy and sell anywhere in the world to take advantage of the most favorable price to the
company7^"3) Take advantage, throughout the world, of changes in labor costs, productivity, trade
agreements, and currency, fluctuations.4) Expand or contract, based on worldwide competitive advantages.5) Obtain a high and rising return on invested capital.6) Achieve greater sales.7) Hold risks within reasonable limits in relation to profits.8) Maximization of shareholders wealth.9) Maximize the return on equity.10) Maintain and improve technological and other company strengths.11) Maintain control of important decisions.12) Encounter fewer barriers in host countries.
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3.5.3. REASONS FOR THE GROWTH OF MULTINATIONAL CORPORATIONS
Reasons for the growth of multinational corporations are as follows:
1) Factor Mobility: Cross border movement of factors of production like technology, capital, labor and even management have paved the way for the growth of MNC. International understanding and economic cooperation has boosted the worldwide flow of factors.
2) Economic Reforms: Governments of most of the developing and underdeveloped economies are facing problems like regressed performance of their public sector and bureaucracy. This has led to the wastage of precious resources resulting in poor GDP rate, which further leads to poverty and unemployment. In order to bring back their economies on track these governments have made several economic reforms. Globalization as a part of such economic reforms has opened their economies to international players.
3) Opening up of Command Economies: Socialism and Communism are giving way to capitalism.4) Management Culture: MNCs generally adapt to local conditions and the relationships between
parent and subsidiary is that of coordinated federation. Decisions on investment financing and market are localized. Corporate strategic planning is essential for enhanced integration and coordination of MNCs global activities. Whereas subsidiary level strategic planning is directed towards localizing the global strategy according to the peculiarities of local condition this autonomous adoption to fast changing Local business Environment is the main reason for the growth of MNCs.
5) Growth Urge: MNCs generally have growth impetus with them. Strategic alliances, joint ventures, wholly owned subsidiaries, mergers, acquisitions; franchising, etc. are the diverse strategies, which MNCs adopt to exploit global opportunities to expand their operations globally. The motives for such expansions are:
i. Securing supplies of minerals, energy and scarce raw materials.ii. Development of technology or brand recognition leading to global demand met through
overseas investment.iii. Availability of cheaper factors overseas, using the same by geographically spreading
their operations MNCs has technology and competitive edge. Global spread is very simple for them unless nations/states are purposely against the entry of MNCs. The most essential element is the urge of MNCs to undertake and integrate manufacturing, marketing, R&D, and finance opportunities on a global scale rather than on domestic scale.
6) Market Potential: MNCs keep an eye on the international market and are always in search of new market. The increasing market potential is great attraction for most of the MNCs at present. MNCs like IBM, Unilever, Coca-Cola, Philips, etc, come in this category.
7) Risk Minimizing: Various agencies with their existence in the field of reducing country risk have again ädded to the cause of growth of MNCs.
8) Development in Communication Technology: The changing face of IT industry has led to the fast communication around the globe. Effective communication being the lifeline of the business
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management, the technological development in the field has removed the boundaries of nation making the whole world a “Global village”.
3.5.4. MULTINATIONAL CORPORATE STRUCTUREMultinational corporations can be divided into three broad groups according to the configuration of their production facilities:
1) Horizontally Integrated Multinational Corporations: They manages production establishments located in different countries to produce the same or similar products. (For example; McDonald’s)
2) Vertically Integrated Multinational Corporations: They manage production establishment in certain country/countries to produce products that serve as input to its production establishments in other country/countries. (For example; Adidas or Nike, Inc.)
3) Diversified Multinational Corporations: They manage production establishments located in different countries that are neither horizontally nor vertically nor straight nor non-straight integrated. (For example; Microsoft or Siemens A.G.)Others argue that a key feature of the multinational is the inclusion of back office functions in each of the countries in which they operate.
3.5.5. FINANCIAL PERFORMANCE MEASUREMENTPerformance measurement is the key in ensuring that an organization’s strategy is successfully implemented. It is about monitoring an organization’s effectiveness in fulfilling its own pre-determined goals or stakeholder requirements. A company must perform well in terms of cost, quality, flexibility, value, and other dimensions.
A performance measurement system that enables a company to meet these demands successfully is essential. It helps ensure better informed and more effective decision-making at both strategic and operational levels.
Financial performance exists at different levels of the organization. This page is mostly concerned with measuring the financial performance of the organization as a whole, and of measuring the performance of key projects. Further measures are used as part of the particular problem of divisional performance appraisal.
3.5.5.1. Mechanics of Performance Measurement
Following steps involved in the performance measurement:
Step I: Establish Standards of Performance: Standards of performance apply to many aspects of the organization, such as cost, quality, and customer service. Cost standards typically incorporate more than one standard since they reflect expected levels of manufacturing performance, such as process yields, product quality, and overhead spending levels.
Establish Standards of Performances
Measure Actual Performance
Analyze Performance and Compare it with Standards
Construct and Implement an Action Plan
Review and Revise Standards
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Step 2: Measure Actual Performance: The organization measures the actual results of the process. Manual or automated data collection systems are required to gather information about the process. In a standard cost system, the information collected usually includes labor hours, machine hours, and materials usage. This information is generally collected on the production floor.
Step 3: Analyze Performance and Compare it with' the Standards: Once the actual results have been measured, these are compared against the standard to identify significant deviations in the expected performance. Managers and their accountants identify and analyze variances on a regular basis. This process is called variance analysis. Variances often signal problems that may require investigation and possible action.
Step 4: Construct and Implement an Action Plan: This step is a critical aspect of any management control system. In a performance system, the variance analysis will highlight potential problem areas. Then management must identify the source of the problem and develop plans to correct or improve the situation. The effectiveness of a performance system depends on management’s ability to act on the information provided.
Step 5: Review and Revise Standards: Modern organizations are in a constant state of change. This dynamic business- environment requires that standards be updated periodically to reflect these changes. Typically standards are updated atleast once a year during the standard-setting process. However, if the variances are significant, the performance standards should be revised during interim periods.
3.5.5.2. Effective Performance Measurement System
Following are the steps which are involved in the development of an effective performance measurement system:
1) The performance measurement system must be integrated with the overall strategy of the business.
2) There must be a system of regular feedback and review of actual results against the original plan and the performance measures themselves.
3) The performance measurement system must be comprehensive. It needs to include the range of factors that contribute to the organization’s success such as competitive performance, quality of service and innovation. This requires a range of financial and non-financial indicators.
4) The system must be owned and supported throughout the organization. The implementation, must be top own so t at individuals setting strategy can determine the objectives and develop appropriate top-level measurement
54
5) Measures need to be fair and achievable. Where performance measures are used to reward managers’ performance, the evaluation should include only the elements they have direct control over.
6) The system and results reporting need to be simple, clear and understandable, particularly to non- finance professionals. There is a need to priorities and focus so that only the key performance indicators for the business in strategic terms are measured.
3.5.5.3. Factors Considered in Performance Measurement
Every control system establishes a standard of performance and compares actual performance with the standard. The most widely used standards are budgeted financial statements. The preparation of the statements is a planning function, but their administration is a controlling function. Budgeted statements are prepared without anticipated inflation or exchange rate fluctuations, but the actual statements are prepared after these phenomena have occurred.
1) Impact of Inflation on Financial Statements: figure presents the effects of a 10 per cent and a 20 per cent rate of inflation on the major accounts of the balance sheet and the income statement. If we assume that one unit is sold every month and that prices increase at an even rate throughout the year, the annual inflation rates reflected on sales would be 5 per cent and 10 per cent instead of 10 per cent and 20 per cent.
If we follow the results of a case having a total annual inflation rate of 10 per cent, or 0.83 per cent per month, annual sales increase to 2,100 — a 5 per cent increase over the budgeted price. The cost of goods sold increases by only 4 per cent from the budgeted cost of 1,500 to the actual cost of 1,560, because the cost of goods sold is based on historical costs. We assumed that interest expenses remain constant. The budgeted depreciation charges are based on historical costs. The combination of higher prices in sales and the use of historical costs in the two major accounts will increase the profits after taxes by 20 per cent from 100 to 120.
The effects of inflation on the balance-sheet accounts depend on the date when assets were acquired or liabilities incurred. Fixed assets and inventory are carried at cost, but accounts receivable and accounts payable are carried at the prices prevailing at the time of the transactions. The budgeted cash of 400 consists of profits after taxes (100), taxes payable (100), and depreciation (200).
Budget Actual with Annual Inflation Rate of: 10% 20%
Income statement (In Foreign Currency)SalesCost of goods sold
Budget Actual with Annual Inflation Rate of: 10% 20%
Balance Sheet (in Foreign Currency)CashAccounts receivableInventory
0200100
400200100
440220110
480240120
Total current assetsPlant and equipmentLess: Depreciation
300350 ----
700350(200)
770350(200)
840350(200)
Total assets Accounts payableNotes payableTaxes payable
350300300 ----
850300300100
920330300120
990360300140
Total current liabilities Equity Retained earnings
60050 ----
70050100
75050120
80040140
Total liabilities and equity 650 850 920 990
2) Impact of Exchange Rate Fluctuation on Financial Statements: Let us assume that a subsidiary purchases its raw materials from country A and sells its finished products to country B. Thus, both exports and imports are denominated in foreign currencies. In this case, exchange rate fluctuations affect the LEVel of both revenues and costs measured in terms of the domestic currency. Table 3.2 shows that an appreciation in the revenue currency (country B’s currency) raises profits, assuming that costs remain constant. In contrast, an appreciation in the cost currency (country A’s currency) reduces profits after taxes unless selling prices are adjusted to reflect the increase in costs.
There are similarities between the effect of inflation and the effect of exchange rate fluctuations on reported profits. If prices in the local currencies are increased by the same percentage as the increase in the cost of imports, the effect of exchange rate fluctuations on profits is identical with the effect of a comparable local inflation rate. A 10 per cent increase in export prices, accompanied by a proportional increase in import prices* produces profits of 120; this is identical to the profit obtained when the local inflation rate was 10 per cent in the example from table 3.2.
Budget B’s Currency Appreciates 10%
A’s Currency Appreciates 10%
Both Currency Appreciates
Sales 2,000 2,J00 1,000 2,100Cost of goods sold 1,500 1,500 1,560 1,560 Gross margin 500 600 440 540
We cannot determine the true impact of exchange rate fluctuations on foreign operations unless a parent’s accounts and those of its subsidiaries are expressed in terms of a homogeneous currency unit. Any changes in the value of the local currency relative to the parent currency will affect the reported profits when financial statements expressed in the local currency are translated into the currency of the parent company. The translation procedure is regulated by the accounting profession.
3.6. MULTINATIONAL CAPITAL STRUCTURE DECISION
3.6.1. INTRODUCTIONA MNC’s capital structure decision involves the choice of debt versus equity financing within all of its subsidiaries.4'Thus, its overall capital structure is essentially a combination of all of its subsidiaries’ capital structures. MNCs recognize the trade-off between using debt and using equity for financing their operations. The advantages of using debt as opposed to equity vary with corporate characteristics, specific to each MNC and specific to the countries where the MNC has established subsidiaries.
3.6.2. SITUATIONS DETERMINING MULTINATIONAL FIRMS CAPITAL STRUCTURE
The MNCs operate in economies where diverse regulations exist for the mobilization of resources by companies. These regulations may be discriminatory for MNCs. Therefore the question of target capital structures has to be analyzed in the light of these regulations. There may be flowing types of situations existing in various economies which are the important determinants of capital structure of MNCs.
1) When a country does not allow the MNCs having headquarters elsewhere to list their stock on its local stock exchange, under these conditions, MNCs would decide to böftbw funds through debt instruments such as bonds and so it may deviate from the target capital structure. In the process, the overall cost of capital may rise. The dependence on debt may be reduced if the host country allows the listing of stocks at the local stock exchange.
2) In the second situation, when the country allows the listing of stock at the local stock exchange then in that case the nature of the project will decide the financing pattern. If the project is not generating net cash flows for some years, say five years or more, then the equity financing is more appropriate. Because in the case, one can avoid net cash out flows by riot paying dividends in the initial years of operation.
Factors Affecting MNCs Capital Structure
MNC’s Guarantees on Debt
Stability of MNC’s Cash Flows
MNC’s Access to Retained Earnings
MNC’s Credit Risk
MNC’s Agency Problems
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3) If a country is facing political turmoil, the use of local banks will be more appropriate, because these banks may be able to prevent MNCs operations in that country from being affected by the political conditions.
3.6.3. FACTORS AFFECTING MNCS CAPITAL STRUCTURE
Following are the factors affecting MNCs capital structure:
1) Stability of MNC’s Cash Flows: MNCs with more stable cash flows can handle more debt because there is a constant stream of cash inflows to cover periodic interest payments. Conversely, MNCs with erratic cash flows may prefer less debt because they are not assured of generating enough cash in each period to make larger interest payments on debt. MNCs that are diversified across several countries may have more stable cash flows since the conditions in any single country should not have a major impact on their cash flows. Consequently, these MNCs may be able to handle a more debt-intensive capital structure.
2) MNC’s Credit Risk: MNCs that have lower credit risk (risk of default on loans provided by creditors) have more access to credit. Any factors that influence credit risk can affect a MNCs choice of using debt versus equity. For example, if an MNC’s management is thought to be strong and competent, the MNCs credit risk may be low, allowing for easier access to debt. MNCs with assets that serve as acceptable collateral (such as buildings, trucks and adaptable machinery) are more able to obtain loans and may prefer to emphasize debt financing. Conversely, MNCs with assets that are not marketable have less acceptable collateral and may need to use a higher proportion of equity financing.
3) MNC’s Access to Retained Earnings: Highly profitable MNCs may be able to finance most of their investment with retained earnings and therefore use an equity-intensive capital structure. Conversely, MNCs that have small levels of retained earnings may rely on debt financing. Growth-oriented MNCs are less able to finance their expansion with retained earnings and tend to rely on debt financing. MNCs with less growth need less new financing and may rely on retained earnings (equity) rather than debt.
Ke
Kw
Kd(1-τ)
DR*Debt/ total
asset
Cost of Capital (%)
0
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4) MNC’s Guarantees on Debt: If the parent backs the debt of its subsidiary, the subsidiary’s borrowing capacity might be increased. Therefore, the subsidiary might need less equity financing. At the same time, however, the parent’s borrowing capacity might be reduced, as creditors will be less willing to provide funds to the parent if those funds might be needed to rescue the subsidiary.
5) MNC’s Agency Problems: If a subsidiary in a foreign country cannot easily be monitored by investors from the parent’s country, agency costs are higher. To maximize the firm’s stock price, the parent may induce the subsidiary to issue stock rather than debt in the local market so that its managers there will be monitored. In this case, the foreign subsidiary is referred to as “partially owned” rather than “wholly owned” by the MNCs parent. This strategy can affect the MNCs capital structure. It may be feasible when the MNCs parent can enhance the subsidiary’s image and presence in the host country or can motivate the subsidiary’s managers by allowing them partial ownership.
3.6.4. OPTIMAL FINANCIAL/CAPITAL STRUCTURE OF MNC
The optimal financial structure of multinational firm takes into account the following:
1) Availability of capital which may affect debt rates.2) Can financial risk of a multinational be reduced through international diversification?3) What should be the financial structure of foreign subsidiary?
There is no conclusive opinion about whether an optimal financial structure exists for a firm. There is a compromise between the Traditional School and the Modigliani and Miller School of thought which states that, when taxes and bankruptcy costs are considered, a firm has an optimal capital structure determined by that particular mix of debt and equity which minimizes the firms cost of capital for a given level of business risk. If the business risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risk. The figure 3.7 shows how the cost of capital varies with the amount of debt employed.
The debt ratio is measured along horizontal axis and the cost of capital along vertical axis, ke is the curve describing cost of equity, kd is the curve describing behavior of cost of debt and kw
represents weighted cost of capital. The figure shows how the cost of capital varies with the amount of debt employed. As the debt ratio (total debt divided by total assets) increases, the overall cost of capital (k) decreases because the heavier weight of low cost dept (kd(l — τ)) compared to high cost of equity.
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The low cost of debt usually is because as debt deductibility of interest as shown by K d (1 -τ). Overall costs of capital continues to decline as debt ratio increases, until financial risk becomes serious that investors and management perceive a real danger of insolvency. This results in sharp increase in cost of debt. This results in U- shape. Cost of capital curve as shown by K e. The optimal capital structure is given by the lowest point of the marginal cost of capital curve. This point gives the optimum debt ratio associated with the lowest cost of capital. In the figure 3.7, the optimum debt ratio is given by DR* and the associated lowest cost of capital by Kd.
3.7. INTERNATIONAL COST OF CAPITAL3.7.1. MEANING OF COST OF CAPITALCost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. .In economic terms, the cost of capital for a particular investment is an opportunity cost - the cost of forgoing the next best alternative investment. In this sense, it relates to the economic principle of substitution, i.e., an investor will not invest in a particular asset if there is a more attractive substitute.
The “market” refers to the universe of investors who are reasonable candidates to provide funds for a particular investment. Capital or funds are usually provided in the form of cash, although in some instances capital may be provided in the form of other assets. The cost of capital usually is expressed in percentage terms, i.e., the annual amount of dollars that the investor requires or expects to realize, expressed as a percentage of the dollar amount invested.
According to Roger Ibbotson, “The opportunity cost of capital is equal to the return that could have been earned op alternative investments at a specific level of risk”.
According to Soloman Ezra, “Cost' of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
In other words, it is the competitive return available in the market on a comparable investment, risk being the most important component of comparability.
3.7.2. COST OF EQUITYThe cost of equity capital is the required rate of return needed to motivate the investors to buy the firm's stock. Calculation of the cost of equity is a difficult process and needs more approximations than calculating the cost of debt. For established firms, the dividend growth model may be used for computing the cost of equity. This model is also called Gordon model.
K e=D1
P0+g
Where,
Ke = Cost of equity capital
D1 = Dividends expected in year one
P0 = Current market price of the firm's stock
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g = Compounded annual rate of growth in dividends or earnings
Alternatively, the cost of equity capital may be calculated by using the modern capital market theory. According to this theory, an equilibrium relationship exists between an asset's required rate of return and its associated risk which can be calculated by the Capital Asset Pricing Model (CAPM).
The cost of equity may be calculated by the CAPM by using the following formula,
E(R) j=Rf +B j(E (R )m−Rf )
Where,
E(R) j is the expected rate of return on asset j. R f is the rate of return on a risk free asset measured by the current rate of return or yield on treasury bonds.
E(R)m is the expected rate of return on a broad market index such as the standard and poor index of industrial stocks.
Bj is the beta of stock j, measured by the relative variability or volatility of the rate of return on the stock compared to the variability of the return on a broad market index. A beta of 1 (unity) denotes a risk equivalent to the one entailed in an investment in a diversified portfolio of stocks.
3.7.3. COST OF DEBTThe term “cost of debt” refers to the effective rate of interest that a company pays on its debt. Cost of debt is the main method of cost of capital in finance and financial management. Cost of debt is calculated on the debt, bonds, loan, or debentures by multiplying interest rate with given amount of debt. If rate is not given, then one can also calculate cost of debt rate. This rate is called “K d”. Cost of debt is calculated by using the following formula:
Cost of debt (without any adjustment) (Kd) = Amount of interest/amount of loan x 100.
In case, company issues the bonds or debenture on premium, at that time, one can calculate cost of debt by following formula:
Cost of debt (Kd) = Interest amount/ (amount of debenture + amount of premium) x 100.
In case, company issues the bonds or debenture on discount, at that time, one can calculate cost of debt by following formula:
Cost of debt (Kd) = Interest amount/ (amount of debenture - amount of discount) x 100
If one has to compare cost of debt with cost of equity, then he have to calculate it after adjustment of tax because interest is deducted from profit before tax but dividend is deducted from profit after tax.
Cost of debt = Amount of interest (1 - Tax Rate)/Amount of loan x 00
For example, interest rate of company is 10% before tax; calculate cost of debt after tax of 30%.
Cost of debt = 10% x (1 - 30%) = 7%
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3.7.4. WEIGH FED AVERAGE COST OF CAPITAL (WACC)
A firm s weighted cost of capital is a composite of (he individual costs of financing weighted by the percentage of financing provided by each source. Therefore, a firm's weighted average cost of capital is a function;
1) The individual cost of capital, and2) The make-up of the capital structure, i.e., the percentage of funds provided by debt, preferred
stock and common stock.
Thus, when a firm has both debt and equity in its capital structure, its financing cost can be represented by the weighted average cost of capital. This can be computed by weighting the after-tax borrowing cost of the firm I and the cost of equity capital using debt ratio as the weight. Specifically
K = (1 - Wd) Ke + Wd (1 - T)i
Where,
K = Weighted average cost of capital
Ke = Cost of equity capital for a levered firm
i = Before-tax borrowing cost
T = Applicable marginal corporate tax rate
Wd = Debt to total market value ratio.
3.7.5. COST OF CAPITAL ACROSS COUNTRIESJust like technological or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways:
1) Increased competitive advantage results to the MNC as a result of using low cost capital obtained from international financial markets compared to domestic firms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares.
2) MNCs have the ability to adjust international operations to capitalize on cost of capital differences among countries, something not possible for domestic firms. Country differences in the use of debt or equity can be understood and capitalized oh by MNCs.
3.7.5.1. Country Differences in Cost of DebtBefore tax cost of debt (Kd) = Rf + Risk Premium
This is the prevailing risk free interest rate in the currency borrowed and the risk premium, required by creditors. Thus the cost of debt in two countries may differ due to difference in the risk free rate or the risk premium.
1) Differences in Risk Free Rate: Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect the risk free rate, these factors include:
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i). Tax Laws: Incentives to save may influence the supply of savings and thus the interest rates, the corporate tax laws may also affect interest rates through effects on "corporate demand for funds.
ii). Demographics: They affect the supply of savings available and the amount of loanable fends demanded depending on the culture and values of a given country. This may affect the interest rates in ä country.
iii). Monetary Policy: It affects interest rates through the supply of loanable funds. Thus a loose monetary policy results in lower interest rates of a low rate of inflation is maintained in the country.
iv). Economic Conditions: A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate.
2) Differences in Risk Premium: The risk premium on the debt must be large enough ^compensate the creditors for the risk of default by the borrowers. The risk varies with the following:
i). Economic Conditions: Stable economic conditions result in a low risk of recession. Thus there is a lower probability of default.
ii). Relationships between Creditors and Corporations: If the relationships are close and the creditors would support the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium.
iii). Government Intervention: If the government is willing to intervene and rescue a-firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk premium.
iv). Degree of Financial Leverage: All other factors being the same, highly leveraged firms would have to pay a higher risk premium.
3.7.5.2. Country Differences in Cost of EquityCost of equity (Ke) = Rf + (Rm- Rf)b
The return on equity can be measured as an interest free rate that could have been earned by the shareholders, plus a premium to reflect the risk of the firm. Since risk free interest rates vary if we describe how finance managers generally pay little attention to what the theory says they should do about their capital structure and across countries, the costs of equity can also vary.
In a country with many investment Opportunities, potential returns may be relatively high, resulting in a high cost of funds and thus a high cost of capital. Issue and floatation costs, the dividends given to the shareholders, withholding taxes and capital gains taxes are some of the variants that affect the cost of equity of the MNC’s cost of equity.
3.7.5.3. Cost of Capital for MNCs Vs Domestic Firms
The cost of capital for an MNC may differ from that of a fully established domestic firm on account of the characteristics of MNCs that differentiate them from domestic firms. These differences include the following:
1) Size of the Firm: Firms that operate internationally are usually much bigger in size than firms which operate only in the domestic market. Firms that operate internationally generally borrow
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substantial amounts of funds and by virtue of their size, they are generally ail a position to reduce the various transaction and brokerage costs and also get preferential treatment from creditors. This helps them to reduce their cost of capital compared to domestic firms.
2) Foreign Exchange Risk: An exceptionally volatile exchange rate, or one that always depreciates, is riot conducive to attracting long-term foreign investors. Such a MNCs cash flow would have wide fluctuations and the capability of the corporation to make various fixed term commitments like interest would get reduced. This may force the shareholders and creditors to demand a higher return which, in turn, increases the MNCs cost of capital. A firm more exposed to exchange rate fluctuations would have a wider spread of possible Cash flows in future periods. Thus, exposure to exchange rate fluctuations could lead to a higher cost of capital.
3) Access to International Capital Markets: The fact that MNCs can normally access the international capital market helps them to attract funds at a lower cost than the domestic firms. In a global context, since the funds are not completely mobile, the cost of funds varies among markets. Also, the subsidiary can obtain local funds at a lower rate than the parent if the prevailing interest rates in the host country are relatively low. This form of financing helps to lower the cost of capital and will generally not increase the MNCs exposure to exchange rate risk.
4) International Diversification Effect: If a firm's cash inflows come from sources all over the world, there might be more stability in them. MNCs like Nike, Coca-Cola, Microsoft, Intel, Procter and Gamble, British Airways, etc., have cash inflows coming from sources all over the world.
5) Political Risk: Political risk can be accounted for in the cost of capital calculations by adding an arbitrary risk premium to the domestic cost of capital for a project of comparable risk. As political risk is likely to be higher in the later years of a project, cash flows in later years tend to get reduced. Thus, political risk impacts the cost of capital of the MNC by moving it upwards as compared to a domestic firm.
6) Country Risk: Country risk represents the potentially adverse impact of a country's environment on the MNCs cash flows. If the country risk level of a particular country begins .to increase, the MNC may consider divesting its subsidiaries located .there. Several risk characteristics of a country may significantly affect the cash flows of the MNC and the MNC should be concerned about the degree of impact likely for each.If the country risk is high and it has invested a high percentage of its assets in such a country, then its probability of bankruptcy is higher. In a situation of high country risk, the cost of capital will also tend to be high.
7) Tax Concessions: MNCs generally choose countries where the tax laws are favorable for them as their net income is substantially influenced by the tax laws in the locations where they operate. In some cases, the MNC may be able to lower its cost of capital by availing of the various tax advantages not available to a purely domestic firm,
3.8. INTERNATIONAL CASH MANAGEMENT3.8.1. MEANING OF CASH MANAGEMENTCash management means optimization of cash flows and the investment of excess cash. Since firms operate in multinational financial environment, therefore cash management is very complex, because of
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different legal environment prevailing in various countries in respect of cross border cash transfers. In addition, the exchange the fluctuations affect the values of these cross border transfers.
3.8.2. OBJECTIVES OF INTERNATIONAL CASH MANAGEMENT
1) The basic objectives of an effective international cash management system are:2) Minimize the currency exposure risk.3) Minimize the country and political risk.4) Minimize the overall cash requirements of the company as a whole without disturbing the
smooth operations of the subsidiary or its affiliate.5) Minimize the transactions costs.6) Full benefits of economies of scale as well as the benefit of superior knowledge.
3.8.3. CASH FLOWS OF A SUBSIDIARYManagement of cash is interwoven with the management of working capital. The subsidiaries in a country not only use local resources, but these also use imports. Therefore, the subsidiary faces a difficult time to forecast future outflows especially when the exchange rate is volatile. Sometimes the subsidiaries expect invoice currency of the supplies to appreciate and desires to build an inventory of imported supplies so that it can draw on inventories to lower the cost of production or it required time to search for an alternative.
The major outflows from a subsidiary are in the following forms:
1) Fees, royalties and dividend (outflow to the parent in foreign exchange).2) Loan repayment (local and foreign).3) Accounts payable (local and foreign), 4) Raw material supplies cash purchases (local and foreign).5) Investments (local and foreign).
These outflows are difficult to forecast because of the following reasons:
1) The exchange rate fluctuations change the value of these outflows,2) The import restrictions may be imposed by the host country, which may change the value of raw
material imports, and3) Future sales of the subsidiary are uncertain, therefore the outflows are uncertain. The sale
volumes of internationally traded goods are more volatile.
The inflows of a subsidiary are:
1) Cash sales (local and foreign currency)2) Accounts receivables (local and foreign currency).3) Interest earning on investments.4) Loan from other sources other than parent (local and foreign).5) Loans from the parent (foreign currency).
The cash flow of a subsidiary is shown in below Figure
Parent
Subsidiary
Long term Projects and Investment
Accounts Payable
Raw Material Suppliers
Accounts Receivable
Source of Debt.
Inventories
Credit Sales
Loans
Interest
Loan
s
Returns
Cash sales
Investments
Inte
rest
/Fee
s and
R
oyal
tics
Cash Sales
Cash Flows
Production
Payments
Payments
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The inflows are also uncertain because a part of inflows of a subsidiary are denominated in foreign exchange. The change in exchange rate, changes the values of these inflows. Other major cause of the change in inflows the change in sale volume. Cash sales and accounts receivable depend on the volume cash and credit sales. Sale volume also depend on the credit standard of a company. If credit standard are lowered, the sales are likely to increase.
Cash Flows of a Subsidiary
After accounting for inflows and outflows, the subsidiary would find itself with either excess cash or deficient cash. Thus it will need either to invest or to borrow cash periodically. If it expects deficiency of cash, then short term financing is needed. The cost of short term domestic financing has to be compared with foreign financing. If the cash is in excess, it has to be invested. Investment market has to be determined. Foreign exchange fluctuations make the return uncertain.
3.8.4. CENTRALIZED CASH FLOW MANAGEMENTThe subsidiaries are more concerned with their own operations rather than the overall performance of the MNC. To maximize the value of the MNC, a value adding cash management system is to be evolved. To reach this objective, a centralized cash management group may need to monitor and manage the parent subsidiary and inter-subsidiary cash flows. This system will be helpful to the company as a whole and to subsidiaries individually because it will be able to help subsidiaries which are over exposed to exchange risk. Below figure shows the overall cash flows of an MNC with two subsidiaries:
Subsidiary A
Subsidiary B
Parent
Short term securities
Long term projects
Source of debt
Stock holders
Interest, principle on account of
Excess cash
Loans debt. Inv.
Fees, royalties and earnings
Sales of Securities
Purchase of securities
Long term investment
Returns
Loans
Excess
Cash
Excess
Cash
Free royalties and earnings
Loans and investment
Interest, principle on account of excess cash
Repayments interest, principle
Funds from new stocks
Cash dividend
Fund
s Su
rplu
s
Fund
s Su
rplu
s
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3.8.4.1. Centralized versus Decentralized Cash Management
A multinational corporation with subsidiaries in different parts of the world has cash flows in a variety of currencies and countries. It can leave cash management to individual subsidiaries (who will also manage their currency exposures) or have a-centralized cash management system. In the latter case it can create a “Cash Management Centre” which may be a part of the parent company, located at one of the subsidiaries or a separate entity incorporated for that purpose. Centralized cash management has several advantages which are discussed below:
3.8.4.2. Location of the Centralized PoolThe centralized pool may be located either in the host country or in the home country or in a third country. The LOCATION depends upon the following factors:
Strength of the Currency of that Country: This means that the currency must be strong.
1) Strength of the Money Market: The stronger and well developed the money market, the greater will be the investment avenues.
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2) Tax Rate: Tax rate should be the lowest. In fact, this is the reason that most of the US multinationals locates their centralized cash pool in tax-haven countries, such as Panama, Cayman Islands, and the Bahamas.
3) Political Stability: The greater the political stability, the easier and safer it will be to locate the centralized pool of cash.
4) Attitude of the Host Government: Pool is located only in those countries where the attitude of the government is congenial towards foreign companies.
3.8.4.3. Advantages of Centralized Cash Management
Following are the advantages of centralized cash management:
1) Netting: In a typical multinational family of companies, there are a large number of intra-corporate transactions between subsidiaries and the parent. If all the resulting cash flows are executed on a bilateral, pair-wise basis, a large number of currency conversions would be involved with substantial transaction costs. With a centralized system, netting is possible whereby the Cash Management Centre (CMC) nets out receivables against payables, and only the net cash flows are settled among different units of the corporate family.
2) Exposure Management: If individual subsidiaries are left to manage their currency exposures, each will have to access the forward market (or other appropriate hedging devices), once again increasing transactions costs. The CMC can adopt a corporate perspective and look at the overall currency composition of receivables and payables. Since the overall portfolio will be fairly diversified, currency risk is considerably reduced. The CMC can match and pair receivables and payables and exploit the close correlations between some currencies — e.g., EUR and GBP — to achieve some degree of natural hedge.
3) Cash Pooling: The CMC can act not only as a netting center but also the repository of all surplus funds. y Under this system, all units are asked to transfer their surplus cash to the CMC, which transfers them among the units as needed and undertakes investment of surplus funds and short-term borrowing on behalf of the entire corporate family. The CMC can, in fact, function as a finance company which accepts loans from individual surplus units, makes loans to deficit units and also undertakes market borrowing and investment. By denominating the intra-corporate loans in the units’ currencies, the responsibility for exposure management is entirely transferred to the finance company and the operating subsidiaries can concentrate on their main business, viz., production and selling of goods and services. Cash pooling will also reduce overall cash needs since cash requirements of individual units will not be synchronous,
3.8.4.4. Disadvantages of Centralized Cash Management
Following are the disadvantages of centralized cash management:
1) Despite these advantages, complete centralization of cash management and funds holding will generally not be possible. Some funds have to be held locally in each subsidiary to meet
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unforeseen payments since banking systems in many developing countries do not permit rapid transfers of funds.
2) Also, some local problems in dealing with customers, suppliers and so on, have to be handled on the spot for which purpose local banks have to be used and local banking relationships are essential.
3) Each corporation must evolve its own optimal degree of centralization depending upon the nature of its global operations, locations of its subsidiaries and so forth.
4) Further, conflicts of interest can .arise if a subsidiary is not wholly owned but a joint venture with a minority local stake. What is optimal with regard to cash and exposure management from an overall corporate perspective need not be necessarily so from the point of view of local shareholders.
3.9. PROJECT FINANCE3.9.1. MEANING OF PROJECT FINANCEProject financing may be defined as the raising of funds required to finance an economically separable capital investment proposal in which the lenders mainly rely on the estimated cashflow from the project to service their loans.
The term ‘project finance’ is generally used to refer to a non-recourse or limited recourse financing structure in which debt, equity, and credit enhancement are combined for the construction and operation, or the refinancing, of ,a particular facility in a capital-intensive industry, in which lenders base credit appraisals on the projected revenues from the operation of the facility, rather than the general assets or the credit of the sponsor of the facility, and rely on the assets of the facility, including any revenue-producing contracts and other cashflow generated by the facility, äs collateral for the debt.
In a project financing, therefore, the debt terms are not based on the sponsor’s credit support or on the value of the physical assets of the project. Rather, project performance, both technical and economic, is the nucleus of project finance.
3.9.2. SOURCES OF PROJECT FINANCEFollowing are the different sources of project finance:
1) Shareholders: These are public or private investors, institutions, or individuals who provide the equity or quasi-equity in a company. Sources of equity includes the following:
i). Retained profit of a company,
Funds raised through the stock market,
ii). Venture capital companies,iii). Joint venture partners, andiv). International investment institutions such as the World Bank.
2) Banks: Banks and other financial institutions are the main providers of debt. Commercial banks are the most readily available to most project investors. They split into retail banks, which provide finance in the local, main-street and merchant banks. There is a large choice available for companies raising finance, and this has led to intense competition. In*choosing a bank, the-decision will not be so much based on the interest rate charged as on the following factors:
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i). The size of the bank,ii). The experience in financing that type of project, and
iii). Any support they may offer with the financial engineering.3) International Financial Markets: International financial markets offer an alternative to domestic
markets, giving easy access to foreign sources of funds. There are many, but the two most important are the Eurocurrency and Eurobond markets. TheiEurocürrency and Eurobond markets are the most efficient in the world and provide for smooth movement of funds. They provide short-term finance at competitive rates but are primarily for large organizations.
4) Institutions: The institutions, i.e., pension funds, insurance funds and trust funds, generally require a fixed, steady income stream and a low level of risk when making an investment or lending money. They will generally consider construction developments only on prime sites with few planning problems, preferably a freehold pre-let scheme, using an established developer. They usually look for large schemes in which to invest. However, the institutions are becoming more flexible and may consider short-term finance. They have also become more prepared to undertake their own developments.
5) Finance for Overseas Projects: A number of additional sources of finance are open to overseas project, in particular.
6) National or International Development Banks: National development organizations and regional or international agencies sometimes offer long-term loans for certain classes of projects at low rates of interest. Each organization or agency has its own pending criteria and the eligibility of a specific project will depend on its size, purpose and sponsorDevelopment banks tend to take a long time to evaluate a project and are likely to impose conditions such as putting-out all construction and equipment contracts to competitive tender. However, they can be helpful in attracting other sources of finance once the project has been approved and will finance supporting infrastructure.
7) Export Credit Finance: Export credit finance should be considered where a project requires capital goods and associated services to be imported because:
i. The term of the loan can sometimes be longer than the term for commercial funds.ii. The rate of interest is often subsidized and fixed for the life of the loan.
iii. The loan is very often available in both local and foreign currency.iv. The buyer credit itself will provide for a loan up to 85% of the cost of eligible goods.
3.9.3. INSTRUMENTS OF PROJECT FINANCINGThe following are the main instruments/means of project finance:
Instruments of Project Financing
Internal Accruals
Equity Shares
Term Loan
Preference Shares
Methods of OfferingVenture Capital
Private Equity
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1) Equity Shares: Equity shares are, earlier, known as ordinary shares or common shares. Equity shareholders are the real owners of the company as they have the Voting rights and enjoy decision-making authority on important matters, related to the company. The shareholders’ return is in the form of dividend, which is dependent on the profits of *the company and capital gain/loss, at the time of their sale. They enjoy higher returns if the company performs well and may not get any dividend, at all, if the company does not do well or when the Board of Directors do not recommend any dividend for payment. Therefore, equity shares are known as ‘variable income security’. They are the last one to get repayment in the event of liquidation of the company.
2) Preference Shares: Preference capital represents a hybrid form of financing - it par takes some characteristics of equity and some attributes of debentures. It resembles equity in the following ways:
i). Preference dividend is payable only out of distributable profits;ii). Preference dividend is not an obligatory payment (the payment of preference dividend
is entirely within the discretion of directors); andiii). Preference dividend is not a tax-deductible payment.
Preference capital is similar to debentures in several ways:
i). The dividend rate on preference capital is usually fixed;ii). The claim of preference shareholders is prior to the claim of equity shareholders; arid
iii). Preference shareholders do not normally enjoy the right to vote.3) Term Loan: Term loans, also referred to as term finance; represent a source of debt finance
which is generally repayable in more than one year but less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin. Term loans differ from short-term bank loans which are employed to finance short-term working capital need and tend to be self-liquidating over a period of time, usually less than one year.
4) Internal Accruals: Internal accruals form part of the means-of-finance in respect of expansion projects. As existing company that goes for an expansion (or diversification or modernization)
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project may opt to finance a portion of the capital investment out of internal cash accruals. Depreciation which is not cash expenditure and profits retained after payment of dividends are the main sources of internally generated funds. Apart from the internal funds that have already been generated, the likely internal generation during the course of project implementation can also be used as a source for funding expansion projects.
5) Methods of Offering: There are different ways in which a company may raise finances in the primary market:
i). Public Issue: By far the most important method of issuing securities, a public issue, involves sale of securities to the public at large. Public issues in India are governed by the provisions of the Companies Act, 1956, SEBI Guidelines on Investor Protection, and the listing agreement between the issuing company and the stock exchanges.The Companies Act describes the procedure to be followed in offering shares to the public and the type of information to be disclosed in the prospectus and the SEBI guidelines impose certain conditions on the issuers besides specifying the additional information to be disclosed to the investors.
ii). Rights Issue: A rights issue involves selling securities in the primary market by issuing rights to the existing shareholders. When a company issues additional equity capital, it has to be offered in the first instance to the existing shareholders on a pro rata basis. This is required under Section 81 of the Companies Act 1956. The shareholders, however, may by a special resolution forfeit this right, partially or fully, to enable a company to issue additional capital to the public.
iii). Private Placement: Private placement and preferential allotment involve sale of securities to a limited number of sophisticated investors such as financial institutions, mutual funds, venture capital funds, banks, and so on.In a preferential allotment, the identity of investors is known when the issuing company seeks the approval of its shareholders, whereas in a private placement, the identity of investors is not known when the offer document (popularly known as the information memorandum) is prepared.In the Indian context we find that broadly, private placement refers to sale of equity or equity related instruments of an unlisted company or sale of debentures of de listed or unlisted company.
6) Venture Capital: Venture capital refers to an equity/equity-related investment in a growth-oriented small/medium business to enable the investors to accomplish corporate objectives, in return for monetary shareholding in the business or the irrevocable right to acquire it. Venture capital is a typical ‘private equity investment’.According to 1995 Finance Bill, “Venture capital is defined as long-term equity investment in novel technology based projects with display potential for significant growth and financial return”.
7) Private Equity: Equity capital that is not quoted on a public exchange is called private equity. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.
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According to Gompers and Learner, “Private equity is defined as dedicated pools of capital which are managed by independent PE firms and focus on equity or equity-linked investments in privately held companies”.
3.9.4. ADVANTAGES OF PROJECT FINANCINGThere are a variety of reasons for the investors to make use of project finance:
1) High Leverage: One major reason for using project finance is that investments in ventures such as power generation or road building have to be long-term but do not offer an inherently high return; high leverage improves the return for an investor.
2) Tax Benefits: A further factor that may make high leverage more attractive is that interest is tax deductible, whereas dividends to shareholders are not, which makes debt even cheaper than equity and hence encourages high leverage.
3) Off-Balance Sheet Financing: If the investor has to raise the debt and then inject it into the project, this will clearly appear on the investor’s balance sheet. A project finance structure may allow the investor to keep the debt-off the consolidated balance sheet, but usually only if the investor is a minority shareholder the project — which may be achieved if the project is owned through a joint venture. Keeping debt-off the balance sheet is sometimes seen as beneficial to a company’s position in the financial markets, but a company’s shareholders and lenders should normally take account of risks involved in any off-balance sheet activities, which are generally revealed in notes to the published accounts even if they are not included in the balance sheet figures; so although joint ventures often raise project finance for other reasons, project finance should not usually be undertaken purely to keep debt-off the investors’ balance sheets.
4) Borrowing Capacity: Project finance increases the level of debt that can be borrowed against a project; non-recourse finance raised by the project company is not normally counted against corporate credit lines (therefore in this sense it may be off-balance sheet). It may thus increase an investor’s overall borrowing capacity, and hence, the ability to undertake several major projects simultaneously.
5) Risk Limitation: An investor in a project raising funds through project finance does not normally guarantee the repayment of the debt — the risk is therefore limited to the amount of the equity investment. A company’s credit rating is also less likely to be downgraded if its risks on project investments are limited through a project finance structure.
6) Risk Spreading/Joint Ventures: A project may be too large for one investor to undertake, so others may be brought-in to share the risk in a joint venture project company. This both enables the risk to be spread between investors and limits the amount of each investor’s risk because of the non-recourse nature of the project company’s debt financing.
7) Long-Term Finance: Project finance loans typically have a longer-term than corporate finance. Long-term financing is necessary if the assets financed normally have a high capital cost that cannot be recovered over a short-term without pushing-up the cost that must be charged for the project’s end-product. So, loans for power projects often run for nearly 20 years, and for infrastructure projects even longer.
8) Enhanced Credit: If the off-taker has a better credit standing than the equity investor, this may enable debt to be raised for the project on better terms than the investor would be able to
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obtain from a corporate loan.9) Unequal Partnerships: Projects are often put together by a developer with an idea but little
money, who then has to find investors. A project finance structure, which requires less equity, makes it easier for the weak developer to maintain an equal partnership, because if the absolute level of the equity in the project is low, the required investment from the weak partner is also low.
3.9.5. DISADVANTAGES OF PROJECT FINANCINGProject financing will not necessarily lead to a lower cost of capital in all circumstances. Project financings are costly to arrange, and these costs may outweigh the advantages explained above.
1) Complexity of Project Financings: Project financing is structured around a set of contracts that must be negotiated by all the parties to a project. They can be quite complex and therefore costly to arrange. They normally take more time to arrange than a conventional financing. Project financings typically also require a greater investment of management’s time than a conventional financing.
2) Indirect Credit Support: For any particular (ultimate) obligor of the project’s debt and any given degree of leverage in the capital structure, the cost of debt is typically higher in a project financing than in a comparable conventional financing because of the indirect nature of the credit support. The credit support for a project financing is provided through contractual commitments rather than through a direct promise to pay. Lenders to a project will naturally be concerned that the contractual commitments might somehow fail to provide an uninterrupted flow of debt service in some unforeseen contingency. As a result, they typically require a yield premium to compensate for this risk.
3) Higher Transaction Costs: Because of their greater complexity, project financings involve higher transaction costs than comparable conventional financings. These higher transaction costs reflect the legal expense involved in designing the project structure, researching and dealing with project-related tax and legal issues, and preparing the necessary project ownership, loan documentation and other contracts.
