Contents of the course

1
International Finance
Part 2 International Corporate Finance
- Lecture n 7 FDI Theory and Strategy
2
Why do firms become multinational?

• Five categories of strategic motives
• Market seekers
• Raw material seekers
• Production efficiency seekers
• Knowledge seekers
• Political safety seekers
• In markets where oligopolistic competition
  subclassified into proactive and defensive
  investments

3
Why do firms become multinational?

• Markets imperfections a rationale for the
  existence of multinational firms
• Imperfections in the market for products
  translate into market opportunities for MNEs.
• Sustaining and transferring competitive advantage
  
• First step Identification
• The competitive advantage must be firm-specific,
  transferable, and powerful enough to compensate
  the firm for the potential disadvantages of
  operating abroad.
• It implies for an MNE to have one or several of
  the following elements, that would give them an
  edge over their local competitors to exploit
  these market opportunities.

4
Why do firms become multinational?

• Sustaining and transferring competitive advantage
  
• The superiority of a MNE may come from
• Economies of scale and scope
• Managerial and marketing expertise
• Advanced technology
• Financial strength
• Differentiated products
• Competitiveness of the Home Market
• It can increase firms competitive advantage in
  operating abroad.
• Referred to as the diamond of national
  advantages.

5
Why do firms become multinational?

• Diamond of national advantages
• Factor conditions availability of appropriate
  factor production
• Demand conditions demanding customers increase
  marketing and quality control skills.
• Related and supporting industries
• Firm strategy, structure and rivalry a
  competitive home market forces firms to fine tune
  their strategy and operational effectiveness.
• Global competitions in oligopolistic industries
  may substitute for domestic competition
  telecom, high-tech, cosmetics...

6
Why do firms become multinational?

• The OLI paradigm and internalisation
• Creates a framework to explain the prevalence of
  FDI over other forms of international expansion.
• The conditions for a successful investment
  require a competitive advantage to be
• O owner-specific can be transferred abroad.
  Ex. Product differentiation.
• L location-specific will be exploitable in
  the targeted market. Ex. Market imperfections or
  competitive advantage.
• I internalisation the competitive position is
  preserved by controlling the entire value chain
  in the industry. Ex. Proprietary information and
  human capital control in research-intensive
  industries.

7
Where to Invest ?

• In theory, a firm should search the best location
  world-wide to take advantage of market
  imperfections and enjoy its competitive
  advantages.
• In practice, firms have been observed to follow a
  sequential search pattern. This relates to two
  behavioral theories of FDI
• Behavioral approach firms tend to invest first
  in countries that are not too far in psychic
  terms and for limited investments. Psychic
  distance is defined in terms of cultural, legal
  and institutional environment. As firms learn,
  they are willing to take more risks, both in
  terms of distance and size of investments.
• International network theory sees MNE as a
  member of an international network with nodes
  based in each of the foreign subsidiaries,
  competing with each other and influencing the
  strategy and the reinvestment decisions.

8
How to Invest Abroad ?

• Modes of Foreign Involvement
• Exporting versus Production Abroad
• Exporting none of the risks faced with FDI
• Disadvantages of exporting inability to
  internalise and exploit the results of RD
  investments.
• Risk of losing markets to imitators and global
  competitors.
• Licensing and Management Contracts vs. Control of
  Assets Abroad
• Licensing popular method to take advantage of
  foreign markets without committing sizeable
  funds. Political risk is minimized.
• Disadvantages of licensing license fees lower
  than FDI profits

9
How to Invest Abroad ?

• Licensing and Management Contracts
• Other disadvantages
• Possible loss of quality control
• Establishment of a potential competitor
• Risk of technology stolen, or becoming outdated
• High agency costs
• In practice, MNEs use licensing with foreign
  subsidiaries or with joint ventures.
• Management contracts are similar to licensing in
  terms of cash-flows, and reduce political risk
  since repatriation of managers is easy.
• Cost effective of licensing with regard to FDI
  depends on the price host countries will pay for
  the services.
• Since MNE continue to prefer FDI, the price is
  assumed to be too low (due to the lack of
  synergies in licensing?)
• MINI - CASE Benecols global licensing
  agreement.

10
How to Invest Abroad ?

• Joint Venture vs. Wholly Owned Subsidiary
• Partially owned foreign business termed as
  foreign affiliate (case of a joint venture).
  Foreign business owned at more 50 foreign
  subsidiary
• Key success factor of a joint venture find the
  right local partner.
• Some advantages of a local partner
• Better understanding of the local market
• Provision of competent management, and/or
  appropriate local technology
• Enhanced contacts and reputation, eased access to
  the local financial markets.
• Potential disadvantages
• Risk of conflicts and difficulties, divergent
  views, decreased control over financing or over
  production rationalisation
• Increased political and reputation risk, if the
  wrong partner is chosen.

11
How to Invest Abroad ?

• Greenfield investment vs. Acquisition
• Greenfield investment establishing a production
  or service facility starting from the ground up.
• Cross-borders acquisitions quicker, could be
  more cost-effective in gaining competitive
  advantage such as technology, brand names,
  logistic and distribution.
• Disadvantages of cross-borders acquisitions
• Problems of paying a too high price (but some
  undervaluation cases, too, especially in crisis
  situation),
• Difficulties on the post-acquisition process, and
  the merger of different corporate cultures.
• Additional difficulties from host governments
  intervention in pricing, financing, employment
  guarantees

12
How to Invest Abroad ?

• Strategic alliances - different stages
• Simple exchange of share ownership (as a takeover
  defense)
• Establishment of a separate joint venture to
  develop and manufacture a product or a service
  (common in high-tech industries)
• Joint marketing and servicing agreement (often
  forbidden by national laws)

13
Multinational Capital Budgeting

• Multinational Capital Budgeting
• Same theoretical framework
• The net present value criteria can be applied
  based on the expected cash flows of the project,
  like in case of a domestic investment.
• Complexities of budgeting a foreign project
• Parent cash flows must be distinguished from
  project cash flows, each contributing to a
  different view of value
• Financing mode, remittance of funds, tax systems,
  differing inflation rates and foreign exchange
  rate movements must be taken into account
• Political risk and government interference should
  be included in the analysis
• Terminal value is more difficult to estimate,
  because of various potential purchasers, in host
  country or abroad, public or private.

14
Multinational Capital Budgeting

• Project versus Parent Valuation
• Strong theoretical statement to analyse the
  project from the point of view of the parent,
  since it is the ultimate basis for dividend
  payments and other reinvestment decisions.
• However, this violates the rule that, in capital
  budgeting, financial cash flows should not be
  mixed with operating cash flows.
• Evaluation of a project from a local viewpoint
  serves some useful purposes and should be
  subordinated to evaluation from the parents
  viewpoint. In practice, firms use both viewpoints
  for evaluation.
• General rules
• Almost any project should be at least giving the
  same return to that on host government bonds,
  that is generally the local risk-free rate
  including a premium reflecting the expected
  inflation rate (Ex. 33 in India).
• Multinational firms should invest only if they
  can earn a risk-adjusted return greater than
  their locally based competitors.

15
Multinational Capital Budgeting

• Illustrative case Cemex enters Indonesia
• See reference textbook Eiteman et al. pp 409 -
  420
• For information and illustration
• Project valuation sensitivity analysis
• First valuation is made on a set of most likely
  assumptions.
• Next, and in particular in uncertain
  environments, a sensitivity analysis is required,
  under a variety of what if scenarios.
• For example, in international projects
• Political risk what if the host country imposed
  controls on dividend payment, what if funds are
  blocked?
• Foreign exchange risk how is the value of the
  project affected by a x decrease (increase) in
  the host currency rate? What about the relative
  impacts of competitiveness and cash flows
  changes?
• Other sensitivity variables change in the
  assumed terminal value, the capacity utilisation
  rate, the initial project cost...

16
Multinational Capital Budgeting

• Real Option Analysis
• For investments that have long lives, cash flows
  returns in later years, or higher levels of risks
  compared to the current business of the firm, are
  often rejected by the DCF approach.
• When MNEs evaluate competitive projects, DCF
  analysis fails to capture the strategic options
  that an investment may offer.
• Real option analysis overcomes this weakness by
  applying option theory to capital budgeting
  decisions. It is a cross between decision-tree
  analysis and pure option-based valuation.
• Very useful when analysing investment projects
  that can take very different values depending on
  the decisions made at certain points in time
  (defer, abandon, reduce capacity,..). The range
  of values give the volatility of the projects
  value.
• MINI-CASE Tridents Chinese Market entry.

17
Adjusting for Risk in Foreign Invt

• Defining risk
• One-sided risk only potential for loss. Example
  expropriation, blocked funds. Often described
  in probabilities of occurrence, qualitative in
  character. Best thought of as acceptable /
  unacceptable.
• Two-sided risk risk of loss or gain. Example
  foreign exchange, host government economic
  policies. Often assessed through statistical
  analysis, allowing rank-order of investments
  alternatives.
• Risk measurement origins
• From the market credit spreads, sovereign
  spreads.
• From institutions constructed indices ranking
  countries on the basis of their macro risk
  fundamentals, i.e. political and economic
  stability. Inherently subjective.

18
Adjusting for Risk in Foreign Invt

• Defining Foreign Investments Risks
• Firm-specific risks micro risks, at project or
  corporate level
• Country-specific risks macro risks, affecting
  the project, but originated at the country level
• Global-specific risks
• see illustration

19
Foreign Investment Risks
20
Adjusting for Risk in Foreign Invt

• Strategies of Foreign Investments Risks
  Management
• Sensitivity Analysis
• Minimize Assets at Risk
• Diversification
• Insurance
• see illustration

21
Risk Management Strategies
Sensitivity Analysis Minimize Assets at Risk
Simulating business plans Minimize equity in
subsidiary Adjusting discount rate Borrow
locally Adjusting cash flows
Diversification Insurance
Plant location Hedging currency risk Source of
debt equity Risk-sharing agreement Currency
of denomination Country investment
agreements Supply sources Investment
guarantees Sales locations
22
Adjusting for Risk in Foreign Invt

• Measuring and Managing Foreign Investments Risks
• Business risk project viewpoint measurement vs.
  parent viewpoint measurement (adjusting discount
  rates or adjusting cash flows), and portfolio
  risk measurement
• Foreign exchange risk see previous lectures
• Governance risk management
• Negotiate investment agreements
• Investment insurance and guarantees specific
  institutions
• Operating strategies after FDI decisions local
  sourcing, facility location, control of
  transportation, control of technology, control of
  markets, brand name and trademark control, thin
  equity base, multiple-source borrowing.

23
Adjusting for Risk in Foreign Invt

• Country-specific risks
• Transfer risk limitations on the MNEs ability
  to transfer funds into and out of the host
  country without restrictions. Restrictions
  usually decided by a government running out of
  foreign currency reserves. Most severe form of
  restriction is non convertibility.
• Three types of reactions for MNEs
• Prior to investment analyse the risks and their
  effects in the project design
• During operations move funds using various
  techniques
• If movements of funds are impossible, find the
  best reinvestment alternatives in the host
  country.

24
Adjusting for Risk in Foreign Invt

• Country-specific risks
• Moving blocked funds techniques
• Use of alternative conduits
• Adapt transfer pricing of goods and services
  between parent and subsidiaries
• Use leading and lagging payments
• and
• Fronting loans parent to subsidiary loan
  channelled through a financial intermediary in a
  third country (link financing)
• Create unrelated exports help easing the
  currency shortage for the host currency
• Obtain special dispensation possible for some
  key industries.

25
Country-Specific Risks
Country-Specific Risks Measurement and Management
26
Adjusting for Risk in Foreign Invt

• Global-specific risks
• Terrorism
• Anti-globalization movement
• The role of international institutions such as
  the IMF and World Bank
• Environmental concerns
• Poverty
• Cyber attacks