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Entering International Markets
Through Investment
Session 4
Foreign Direct Investment: Definition



Foreign direct investment occurs when a
firm
 invests directly in facilities
 to produce and /or market a product
in a foreign country
Purchase of physical assets or significant
amount of ownership of a company in
another country to gain some measure
of management control
By contrast, portfolio investment does
not involve obtaining a degree of control
in a company
FDI vs. Export and Licensing
COUNTRY A
Export
Transfer of products
- Logistical disadvantages
Licensing
Transfer of technology
- Lack of control
Investment
Transfer of the whole value
chain (managerial, marketing,
financial, and other skills
(“knowlwdge assets”))
+ Allows company to expoit
its competitive advantages
more fully
COUNTRY B
Types of Foreign Direct Investment

Green-field investment

Establishment of a new
operation

Merger / Acquisition
Acquiring or merging
with an existing firm




a minority 10-49%
majority: 50-99%
full out-right (completely)
stake: 100%
Drivers of Foreign Direct Investment







Getting access to national markets
Establish low cost manufacturing locations from which to
serve regional or global markets
Important to have production facilities based close to
their major customers
Firms fear protectionist pressures
Way of circumventing trade barriers
Political and economic changes – shift toward democratic
political institutions and free market economies
Globalization of the world economy
Types of Foreign Investors
Extractive
investors
Establish foreign subsidiaries to exploit natural resources in
order to acquire raw materials for their own industrial
operations (backward vertical integration) or for sale on world
markets. Ordinarily, these investors sell only a small fraction of
their raw materials output in the foreign country of extraction.
Sourcing
investors
Establish foreign operations to manufacture products that are
entirely or mainly exported to the home country or to third
countries. The purpose of sourcing investments is to obtain
lower-cost supplies of components, parts, or finished goods by
taking advantage of abundant endowments of labour, energy, or
other inputs in a foreign country.
Market
investors
Account for the most manufacturing abroad. Their objective is
to penetrate target market from a production base inside the
country.
General investment framework

The fundamental question of a foreign investment falls into the
general framework of opportunities and risks analysis
High
Low risk
High return
High
Attractiveness
Low
Attractiveness
High Risk
Low Return
Market and
Competitive
Opportunities
Low
Low
Risks
High
Advantages and disadvantages of
investment entry mode
Advantages
Disadvantages
1. Local production may lower the costs of supplying a
foreign target market as compared to export entry,
because of savings in transportation and customs duties
and/or lower manufacturing costs resulting from less
expensive local inputs (labor, raw materials, energy, etc.).
2. Local production may increase the availability of supply
if quotas limit imports or if a company’s supply of export
products is constrained by plant capacity in the home
country.
3. May enable a manufacturer to obtain a higher or more
uniform quality of supply in the target country
(compared to licensing).
4. May create marketing advantages through product
adaptation to local preferences and purchasing power.
5. Quicker and more reliable provision of goods to
middlemen and cusotmers, better provision of after-sales
service, direct distribution through own sales force and
local company image.
1. Requires
substantialy more
capital, management
and other company
resources.
2. Higher exposure to
risks
3. High startup costs
4. Long pay-back
periods
5. Difficulty of
disinvestment in the
event of failure
Framework for Foreign Market Entry
Decision
Should we investigate this foreign
investment proposal?
No
Yes
Is the current investment climate of the
foreign target country acceptable?
No
Yes
Will the investment climate remain
acceptable over our planning period?
No
Reject
Yes
Does our economic analysis indicate
that the investment project will meet
ROI and other objectives, after taking
account of risks?
Yes
Have our entry negotiations with the
host government reached a satisfactory
outcome?
Yes
INVESTMENT ENTRY
No
Yes
No
Yes
Can we
redesign the
project?
Should we
continue
negotiations?
No
No
Analyzing the foreign investment
climate
Political
environment



Economic
environment
Social
environment
(1) Which variables in the
investment climate are critical to
the success of the project?
(2) What is the present behavior
(value) of these critical variables?
(3) How are these critical variables
likely to change over the
investment planning period?
Cultural
environment
Checklist for evaluating the Investment
Climate in a foreign Country (1)
A. Genral political stability
1.
2.
3.
4.
5.
Past political bahavior
Form of govenment
Strenght/ideology of government
Strenghts/ideologies of rival political groups
Political, social, ethnic, and other conflicts
B. Government Policies Toward Foreign Investment
1.
2.
3.
4.
5.
6.
7.
8.
9.
Past experience of foreign investors
Attitude toward foreign investment
Foreign investment treaties and agreements
Restrictions on foreign ownership
Local content requirements
Restrictions on foreign staff
Other restrictions on foreign investment
Incentives for foreign investment
Investment entry regulations
Checklist for evaluating the Investment
Climate in a foreign Country (2)
C. Other Government Policies and Legal Factors
1.
2.
3.
4.
5.
6.
7.
8.
9.
Enforceability of contracts
Fairness of courts
Corporate/Business Laws
Labor laws
Taxation
Import duties and restrictions
Patent/trademark protection
Antitrust/restrictive practices laws
Honesty/efficiency of public officials
D. International Payments
1.
2.
3.
4.
Balance of payments
Foreign exchange position/external indebtness
Repatriation restrictions
Exchange rate behaviour
Checklist for evaluating the Investment
Climate in a foreign Country (3)
E. Macroeconomic Environment
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Role of government in the economy
Government development plans/programs
Size/growth rate of gross national product
Size/growth rate of population
Size/growth rate of per-capita income
Distribution of personal income
Sectorial distribution of industry, agriculture, and services
Transportation/communications system
Rate of inflation
Government fiscal/monetary policies
Price controls
Availability/cost of local capital
Management-labour relations
Membership in customs unions or free trade areas
Evaluation Political Risks





How likely is general political instability in the host
country over investment planning period?
Barring a general political collapse, how long is the
present government likely to remain in power?
How strong is the present government’s
commitment to the current rules of the game (e.g.
ownership rights) in light of this attitude toward
foreign investors (ideology) and its power position?
If the present government is succeeded, what
changes in the current rules of the game would the
new government be likely to make?
How would likely changes in the rules of the game
affect the safety and profitability of our investment
project?
Rationale behind FDI: Dunning’s
Eclectic Paradigm (1976)

Attempts to integrate three general and interrelated concepts to identify
and evaluate the significance of factors influencing both the initial act of
cross-border production by firms and the growth of such production.



Why firms undertake international production
Where the production would take place and
How and why multinational firms could earn better profits than domestic producers
in the host countries could.
LOCATION-SPECIFIC
ADVANTAGES
(optimal location)
OWNERSHIP-SPECIFIC
ADVANTAGES
(specific assets)
INTERNALIZATION
ADVANTAGES
(efficiency)
Dunning’s Eclectic Paradigm:
Ownership Advantages





The standard advantages are advantages a firm may have compared to
other firms in a specific location.
These advantages are mainly related to the size and established position
an already established firm enjoys, and in some cases, monopoly power.
Ownership advantages are often related to product diversification and
exclusive access to technology, patents and markets and use of input
factors like labour, finance, information and natural resources.
Ownership advantages may
lead both to market
efficiency and economies of
scale.
Brand name and quality are
important elements in this
category.
Dunning’s Eclectic Paradigm:
Internalization Advantages

Benefits derived from belonging to a large organization


Affiliate may benefit from economies of joint supply in production,
purchasing, finance and marketing, and in addition get access to cheaper
inputs like administration, management, R&D, marketing and human capital
from the parent company.
Benefits of being an MNE

Being an MNE means that a firm is in a
better position to take advantage of
different factor endowments, factor prices
and tax regimes. The firm has the ability to
exploit its technological and managerial
expertise in several countries, and could
gain access to further markets.
Dunning’s Eclectic Paradigm:
Location Advantages

Access to and the relative cost of production factors


Taxes and trade barriers


Only firms in a certain geographical location can exploit these factors. This
might be natural resources as well as man-made resources
These are policies by governments and are subject to change (government
intervention, tax rates, incentives, investment climate, political stability and
control on imports)
Transportation cost and access to
market

In many industries, where the quantity
and volume are high and the ratio of
sales price to transportation cost is
relatively high, distance and
transportation cost are of importance.
FDI is a best entry strategy when

Firm has valuable know-how that cannot be adequately
protected by a licensing contract

Firm needs tight control over a foreign entity to maximize its
market share and earnings in that country

Firm’s skills and know-how are not amenable to licensing
FDI costs and benefits:
Host country perspective
BENEFITS
Resource transfer effects
COSTS
Adverse effects on competition
Employment effects
Adverse effects on balance of
payments
• Supplying capital, technology &
management resources
• Brings jobs directly by MNE employing
& indirectly by suppliers employing
• MNE tend to pay higher wages
Balance of payment effects
• Tracks payments to & receipts from
other countries
• FDI can substitute for imports, & can
export to other countries
Effects on competition & economic
growth
• Green-field increases the number of
players, increase competition
• Competition drive down prices &
benefit consumers
• Increased productivity, innovation &
economic growth
• MNE subsidiaries may have greater
economic power than indigenous firms
•Too much importing of components vs
local sourcing
Perceived loss of national
sovereignty
• Key decisions that effect host economy
will be made by foreign parent with no
commitment to & no control by host
country
FDI costs and benefits:
Home country perspective
BENEFITS
Inward flow of foreign
earnings
• May also create demand for
home country exports of
equipment & goods
Employment effects
• Jobs created by demand for
exports
MNE learns valuable skills
that can be transferred back
• Reverse resource-transfer
contributing to home country
economic growth rate
COSTS
Balance of payments
• Suffers from initial capital outflow
to finance FDI
• Suffers if purpose to supply home
market from low-cost production
location
• Suffers if the FDI is substitute for
direct exports
Employment effects
• Suffers when FDI is substitute for
domestic production – reduced
home country employment
FDI & Government Policy:
Home country perspective
POLICIES FOR ENCOURAGING
OUTWARD FDI
Foreign risk insurance
• Risks of expropriation
(nationalization)
• War losses
• Inability to transfer profits back
home
Capital assistance
• Special funds or banks to make
government loans to encourage
domestic firms to undertake FDI
Tax incentives
• Eliminate double taxation of foreign
income (host & home governments)
Political pressure
• Use political influence to encourage
host countries to reduce FDI
restrictions
RESTRICTING OUTWARD FDI
• Limit capital outflows out of
concern for the balance of payments
• Manipulated tax rules to encourage
their firms to invest at home – create
jobs at home
• Countries sometimes prohibit
national firms from investing in
certain countries for political reasons.
(Cuba, South Africa)
FDI & Government Policy:
Host country perspective
POLICIES ENCOURAGING
INWARD FDI
Offer incentives for foreign firms to
invest in their countries
• Tax concessions
• Low-interest loans
• New state spending on
infrastructure
• Grants or subsidies
Desire to gain from the resource
transfer and employment effects
Desire to capture FDI away from
other potential host countries
RESTRICTING INWARD FDI
Ownership restraints
• Foreign companies excluded from
specific fields – national security or
competition (infant industry)
• Significant proportion of the equity
of the subsidiary must be owned by
local investors – maximize resourcetransfer & employment benefits
Performance requirements
• Maximize the benefits and minimize
the costs
• Related to local content, exports,
technology transfer & local
participation by top management
Assessing the profitability of an
Investment Entry Project (1)
A. Market factors
1.
2.
3.
4.
5.
6.
7.
Size an prospective growth (sales potential) of target
market fpr project’s product line
Competitive situation
Export sales potential of project’s product line
Displacement of investor’s (parent company’s) exports to
target market
Projected new export sales to target market of investor’s
finished products
Marketing/distribution infrastructure
Required scope/cost of marketing effort
Assessing the profitability of an
Investment Entry Project (2)
B. Production/Supply factors
1.
2.
3.
4.
5.
6.
Required capital investment in production facilities
Availability/cost of plant site
Availability/cost of local raw materials, energy and other
non-labour inputs
Availability/cost of imported inputs from parent company
Availability/cost of imported inputs from other sources
Transportation, port and warehousing facilities
Assessing the profitability of an
Investment Entry Project (3)
C. Labour factors
1.
2.
3.
4.
5.
6.
7.
Availability/cost of local managerial, technical and office
staff
Availability/cost of expatriate staff
Availability/cost of skilled, semi-skilled, and unskilled
workers
Fringe benefits
Worker productivity
Training facilities and programs
Labour relations
Assessing the profitability of an
Investment Entry Project (4)
D. Capital sourcing factors
1. Availability/cost of local long-term investment capital
2. Availability/cost of local working capital
3. Availability/value of host government financial incentives
4. Required investment by parent company
E. Tax factors
1. Kinds of taxes and tax rates
2. Allowable depreciation
3. Tax incentives/exemptions
4. Tax administration
5. Tax treaty with investor’s country
Summary Cash Flow Analysis of a
foreign Investment Project
End of year
Net post-tax cash inflows
Present value factor at 15%
Net present value of post-tax cash inflows
Cummulative net present value of cash
inflows
0
1
2
3
4
5
(200)
25.0
50.0
100.0
100.0
100.0
1.0
0.870
0.756
0.658
0.572
0.497
(200)
21.8
37.8
65.8
57.2
49.7
(74.6)
(17.4)
32.2
(200)
(178.2) (140.4)
Types of integration through FDI

Horizontal integration


Investing in the same industry as in the home
market
Vertical integration


Extends company’s activities into stages of
production that provide its inputs (backward
integration)
or absorb its out-puts (forward integration)