International Financial Management 10

7/31/2019 International Financial Management 10

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Chapter 10Direct Foreign Investment


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Objectives

The main purpose of this chapter is to illustrate why

MNCs often use DFI and to suggest various factors

involved in the DFI decision. This chapter covers in

general terms as to the costs and benefits of DFI, ( thespecifics involved in quantifying costs and benefits will

be discussed in the following chapter). This chapter

implicitly suggests that each firm may benefit from DFI

by capitalizing on some unique perceived advantages ofthe foreign market. Yet, all DFI decisions relate to the

MNCs overall risk and return objectives.

The specific objectives are :


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Objectives

to describe common motives for initiatingdirect foreign investment (DFI); and

to illustrate the benefits of internationaldiversification.


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Topics for Pre-classDiscussion

Why would a large advanced MNC consider DFI in some less

developed country?

Assume that you produce plastic computer pieces for computer

companies. The pieces require very little technology. Where would

you like to establish DFI?

What factors would be considered when deciding whether a

subsidiary should reinvest earnings or remit them to the parent?

The DFI decision is related to marketing, finance, and management.

What is the role of each area in the DFI decision? Do you think foreign investments are primarily intended to reduce

production costs or increase sales? Discuss.


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Motives for DFI

DFI can improve profitability and enhance

shareholder wealth, either by boosting

revenues or reducing costs.Revenue-Related Motives

* Attract new sources of demand,

especially when the potential for growth in

the home country is limited.


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Motives for DFI

Revenue-Related Motives

* Enter profitable markets.

* Exploit monopolistic advantages,especially for firms that possess resourcesor skills not available to competing firms.

* React to trade restrictions.* Diversify internationally.


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Motives for DFI

Cost-Related Motives

* Fully benefit from economies of scale,especially for firms that utilize much

machinery.* Use cheaper foreign factors of

production.

* Use foreign raw materials, especially ifthe MNC plans to sell the finished productback to the consumers in that country.


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Motives for DFI

Cost-Related Motives

* Use foreign technology.

* React to exchange rate movements,such as when the foreign currencyappears to depreciate. DFI can also helpreduce the MNCs exposure to exchange

rate fluctuations.


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Motives for DFI

The optimal method for a firm to penetrate

a foreign market is partially dependent on

the characteristics of the market. For example, if the consumers are used to

buying domestic products, then licensing

arrangements or joint ventures may bemore appropriate.


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Motives for DFI

Before investing in a foreign country, thepotential benefits must be weighed against thecosts and risks.

Financial market conditions should beconsidered along with product markets whenmaking DFI decisions.

As conditions change over time, some countriesmay become more attractive targets for DFI,while other countries become less attractive.


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Benefits of InternationalDiversification

The key to international diversification is toselect foreign projects whose performancelevels are not highly correlated over time.

Example: P273 - 275


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Diversification Benefits for

Merrimack Co.Merrimack Co. is a U.S. firm that is considering the location of anew investment project.

Characteristics of Proposed

Project If Located in

the U.S. the U.KProjects mean expected 25% 25%

annual after-tax return

Standard deviation of .09 .11

projects return

Correlation of projects .80 .02

return with return on

existing U.S. business


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Merrimack Co.

In terms of return, neither new project has

an advantage.

With regard to risk, the new project isexpected to exhibit slightly less variability

in returns if located in the U.S.


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Merrimack Co. Suppose that the project constitutes 30% of

Merrimacks total funds, and that the standard

deviation of Merrimacks return on existing U.S.

business is .10. If the new project is located in the U.S., theportfolio variance for the overall firm

= W2A2A +W2B2B +2 WA WBAB CORRAB

= (.70) 2(.10) 2+(.30) 2 (.09) 2 +2(.70)(.30)(.10)(.09)(.80)= .008653


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Merrimack Co If the new project is located in the U.K., the

portfolio variance for the overall firm

= W2A2A +W2B2B +2 WA WBAB

CORRAB= (.70) 2(.10) 2 +(.30) 2(.11) 2

+2(.70)(.30)(.10)(.11)(.02)

= .0060814 Thus, as a whole, Merrimack will generate more

stable returns if the new project is located in the

U.K.


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An MNC may not be insulated from a globalcrisis, since many countries will be adverselyaffected.

However, as can be seen from the 1997-98Asian crisis, an MNC that had diversified among

the Asian countries might have fared better than

if it had focused on one country. Even betterwould be diversification among the continents.


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As more projects are added to a portfolio, the

portfolio variance should decrease on average,

up to a certain point.

The degree of risk reduction is greater for aglobal portfolio than for a domestic portfolio, due

to the lower correlations among the returns of

projects implemented in different economies.


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An MNC with projects positioned around the world isconcerned about the risk and return characteristics of itsprojects.Example: Risk- Return Analysis of International Projects

(Exhibit 10.1)

Virginia, Inc., considers a global strategy of developing

projects as shown in Exhibit 10.1. Each point on thegraph reflects a specific project that either has beenimplemented or is being considered.( The return axis may

be measured by potential return on assets or return onequity. The risk may be measured by potential fluctuationin the returns generated by each project.)

E l Ri k R t A l i


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Example: Risk- Return Analysis

of International Projects

Exhibit 10.1 shows that Project A has the highestexpected return of all the projects, yet its risk is also toohigh. Thus, Virginia may develop a portfolio of projects.By combining Project A with several other projects, it

may decrease its expected return, as well as risk. If Virginia combines projects, its project portfolio may beable to achieve a risk-return tradeoff exhibited by any ofthe points on the curve in Exhibit 10.1. This curverepresents a frontier of efficient project portfolios that

exhibit desirable risk-return characteristics, in that nosingle project could outperform any of these portfolios.As new projects are proposed, the frontier of efficientproject portfolios available to Virginia may shift.

E ample Risk Ret rn Anal sis


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Example: Risk- Return Analysis

of International Projects

Exhibit 10.1 Risk-Return Analysis of International Projects

.

.. .

..

.A

BC

D E

FG

Risk

ExpectedReturn

Frontier of Efficient

Project Portfolios


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Project portfolios along the efficient frontier

exhibit minimum risk for a given expected

return. Of these efficient portfolios, an MNC may

choose one that corresponds to

willingness to accept risk.


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The frontiers of efficient project portfolios

of some MNCs are more desirable than

the frontiers of other MNCs.(Exhibit 10.2)


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Exhibit 10.2 Risk-return Advantage of a Diversified MNC

Efficient frontier of projectportfolios for MNC that sellssteel to European nations

Efficient frontier of projectportfolios for multiproduct MNC

Risk

Expe

cted

Return


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Decisions Subsequent to DFI

Some periodic decisions are necessary.

Should further expansion take place?

Should the earnings be remitted to the parent,

or used by the subsidiary?

The appropriate decisions depends on the

economic conditions in the subsidiarys country

and the parents country, as well as restrictions

imposed by the host country government.


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Host Government View of DFI

For the government, the ideal DFI solves

problems such as unemployment and lack of

technology without taking business away from

the local firms.

The government may provide incentives to

encourage the forms of DFI that it desires, and

impose preventive barriers or conditions on the

forms of DFI that it does not want.


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The ability of a host government to attract DFI is

dependent on the countrys markets and

resources, as well as government regulations

and incentives.

Common incentives offered by the host

government include tax breaks, discounted rent

for land and buildings, low-interest loans,

subsidized energy, and reduced environmental

restrictions.


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Common barriers imposed by the host

government include the power to block a

merger/acquisition, foreign majorityownership restrictions, excessive

procedure and documentation

requirements (red tape), and operationalconditions.


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Questions and Applications

*1. Describe some potential benefits to an MNC as aresult of DFI. Elaborate on each type of benefit.

2. Bear Co. and Viking, Inc., are automobilemanufacturers that desire to benefit from economies of

scale. Bear Co. has decided to establish distributorshipsubsidiaries in various countries, while Viking, Inc., hasdecided to establish manufacturing subsidiaries invarious countries. Which firm is more likely to benefitfrom economies of scale?

3. Once an MNC establishes a subsidiary, DFI remainsan ongoing decision. What does this statement mean?


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4. Packer, Inc., a U.S. producer of computer

disks, plans to establish a subsidiary in

Mexico in order to penetrate the Mexican

market. Packers executives believe that theMexican pesos value is relatively strong and

will weaken against the dollar over time. If

their expectation about the peso value are

correct, how will this affect the feasibility of the

project? Explain.


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5. Offer your opinion on why economies of some

less developed countries with strict restrictions

on international trade and DFI are somewhat

independent from economies of othercountries. Why would MNCs desire to enter

such countries? If these countries relaxed

their restrictions, would their economies

continue to be independent of other

economies? Explain.


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6. In August 2001, Ohio, Inc., consideredestablishing a manufacturing plant in centralAsia, which would be used to cover its exportsto Japan and China Hong Kong. The cost oflabor was very low in Central Asia. OnSeptember 11, 2001, the terrorist attacks onthe United States caused Ohio to reassess the

potential cost savings. Why would theestimated expenses of the plant increase afterthe terrorist attacks?


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7. J.C. Penny has recognized numerous opportunities to

expand in foreign countries and has assessed many

foreign markets, including Brazil, Greece, Mexico,Portugal, Singapore, and Thailand. It has opened new

stores in Europe, Asia, and Latin America. In eachcase, the firm was aware that it did not have sufficient

understanding of the culture of each country that it had

targeted. Consequently, it engaged in joint ventures

with local partners who knew the preference of thelocal customers.


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a. What comparative advantage does J.C. Pennyhave when establishing a store in a foreigncountry, relative to an independent varietystore?

b. Why might the overall risk of J.C. Pennydecrease or increase as a result of its recentglobal expansion?

c. J.C. Penny has been more cautious aboutentering China. Explain the potential obstaclesassociated with entering China.

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International Financial Management 10

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