-
Chapter 16 Foreign Direct Investment and International Capital
Budgeting
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MoosaSlides prepared by Afaf MoosaObjectives To discuss the
characteristics of FDITo outline the theories of FDITo describe the
techniques of international capital budgetingTo examine the
implications of taxation, country risk and transfer prices for
international capital budgeting16-*
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MoosaSlides prepared by Afaf MoosaDefinition An investment project
is classified as direct investment if the investor acquires
significant control over a firm16-*
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MoosaSlides prepared by Afaf MoosaWhat is significant
control?Ownership of 10-25%United States, Japan and Australia:
10%France, Germany and United Kingdom: higher thresholdBelgium and
the Netherlands: no specific number16-*
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MoosaSlides prepared by Afaf MoosaReasons for interest in FDI Rapid
growth and changing pattern of FDI Concern about causes and
consequences of foreign ownership FDI channels resources to
developing countriesThe role played in transforming ex-communist
countries16-*
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MoosaSlides prepared by Afaf MoosaModes of foreign market
entryExport of the goods produced in the source countryLicensing a
foreign company to use technologyForeign distribution of products
through a subsidiaryForeign (international) production16-*
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MoosaSlides prepared by Afaf MoosaChoice between exporting and
FDIProfitability Opportunities for market growthProduction cost
levelsEconomies of scale
16-*
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MoosaSlides prepared by Afaf MoosaLicensingThis involves the supply
of technology and know-how or the use of a trademark or a patent
for a feeIt offers one way to generate revenue from foreign markets
that are otherwise inaccessible16-*
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MoosaSlides prepared by Afaf MoosaFranchisingCompanies with
brand-name products move offshore by granting foreigners the
exclusive right to sell their products in a designated area16-*
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MoosaSlides prepared by Afaf MoosaTypes of FDIGreenfield
investmentBrownfield investmentMergers and acquisitionsJoint
ventures16-*
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MoosaSlides prepared by Afaf MoosaChoice between greenfield
investment and M&AsFirms with lower R&D intensity, more
diversified firms and large multinationals are more inclined to
indulge in M&AsInter-country cultural and economic differences
reduce the tendency for M&As16-*(cont.)
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaChoice between greenfield
investment and M&As (cont.)Multinationals with subsidiaries
prefer acquisitions.The tendency for M&As depends on the supply
of target firmsSlow growth in an industry encourages
M&As16-*
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MoosaSlides prepared by Afaf MoosaTheories of FDIA number of
theories or hypotheses have been put forward to explain FDI16-*
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MoosaSlides prepared by Afaf MoosaThe differential rates of return
hypothesisCapital flows from countries with low rates of return to
countries with high rates of return16-*
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MoosaSlides prepared by Afaf MoosaThe diversification hypothesisThe
choice among various projects is determined by expected return and
risk16-*
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MoosaSlides prepared by Afaf MoosaThe output and market size
hypothesisThe volume of direct investment in one host country
depends on sales or market size16-*
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MoosaSlides prepared by Afaf MoosaThe industrial organisation
hypothesisA firm indulges in FDI despite inter-country differences
because it has some advantages such as brand name, patent,
managerial skills, etc.16-*
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MoosaSlides prepared by Afaf MoosaThe internalisation hypothesisFDI
arises from efforts by firms to replace market transactions with
internal transactions16-*
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MoosaSlides prepared by Afaf MoosaThe location hypothesisFDI exists
because of the international immobility of some factors of
production16-*
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MoosaSlides prepared by Afaf MoosaThe eclectic theoryThree
conditions must be satisfied if a firm is to engage in FDI:It must
have comparative advantagesIt is better to use rather than lease
these advantagesIt is more profitable to use these advantages with
factor inputs abroad16-*
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MoosaSlides prepared by Afaf MoosaThe product life cycle
hypothesisWhen a product is standardised, the innovator may decide
to invest in developing countries to obtain some advantages, such
as cheap labour16-*
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MoosaSlides prepared by Afaf MoosaThe oligopolistic reaction
hypothesisFDI by one firm triggers similar investment by other
leading firms in an attempt to maintain market share16-*
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MoosaSlides prepared by Afaf MoosaThe internal financing
hypothesisFDI is determined by the foreign subsidiaries internally
generated funds16-*
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MoosaSlides prepared by Afaf MoosaThe currency areas
hypothesisCountries with strong currencies tend to be sources of
FDICountries with weak currencies tend to be recipients of
FDI16-*
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MoosaSlides prepared by Afaf MoosaDiversification with barriers to
capital flowsFDI arises from the desire to diversify through two
conditions:Barriers or costs to portfolio flowsMultinationals
provide diversification opportunities16-*
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MoosaSlides prepared by Afaf MoosaPolitical stability and riskLack
of political stability discourages FDI inflowsPolitical risk arises
because of unexpected modifications of the legal and fiscal
framework in the host country16-*
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International Finance: An Analytical Approach 3e by Imad A.
MoosaSlides prepared by Afaf MoosaTax policiesTax policies affect
incentives to engage in FDI because:tax treatment of income
generated abroad affects the rate of returntax treatment of income
generated at home affects relative profitabilitytax policies affect
the relative cost of capital16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaGovernment regulationsRegulations
may provide incentives (such as tax credits and
exemptions)Regulations may provide disincentives (such as slow
processing of required authorisation)16-*
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MoosaSlides prepared by Afaf MoosaStrategic and long-term
factorsThe desire to defend foreign markets against competitorsThe
desire to gain and maintain a foothold in a protected marketThe
need to develop a parent-subsidiary relationship16-*(cont.)
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaStrategic and long-term factors
(cont.)The desire to induce the host country into a long-term
commitment to a particular type of technologyThe advantage of
complementing another type of investmentThe economies of new
product developmentCompetition for market shares among
oligopolists
16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaEvaluating direct investment
projectsAccounting rate of return Payback periodNet present value
(NPV)Internal rate of return (IRR)16-*
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MoosaSlides prepared by Afaf Moosa
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a
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MoosaSlides prepared by Afaf MoosaAccounting rate of return This is
the percentage return on capitalThe method is criticised because:it
is based on profit rather than cash flowsit ignores the size of the
project and the time value of money16-*
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MoosaSlides prepared by Afaf MoosaPayback periodThe payback period
measures how quickly the cost is recoveredIt is based on cash
flowsIt ignores the time value of money and the cash flows arising
after the payback period16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaNet present value 16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaInternal rate of return 16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaAdjusting project assessment for
riskRisk-adjusted discount rateRisk-adjusted cash flowsSensitivity
analysis16-*
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MoosaSlides prepared by Afaf MoosaEvaluating FDI projectsTwo
problems:Measurement of cash flowsChoice of discount rate 16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaProblems of cash flow
measurementCash flows accruing to the parent company and the
subsidiary are different because of:different tax ratesrestrictions
on remittancesexcessive remittanceschanges in exchange
rates16-*
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MoosaSlides prepared by Afaf MoosaForecasting cash flowsDemand for
the product Price of the product Variable costsFixed costsProject
lifetime16-*(cont.)
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MoosaSlides prepared by Afaf MoosaForecasting cash flows
(cont.)Salvage value Remittance restrictionsTax rates and
lawsExchange rates16-*
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MoosaSlides prepared by Afaf MoosaThe evaluation processEstimating
incremental cash flows Estimating remittable cash flows in domestic
currencyIncorporating indirect costs and benefits Discounting cash
flows16-*
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MoosaSlides prepared by Afaf MoosaThe cost of capitalThis is the
minimum risk-adjusted rate of return required in order for the
investment to be acceptedIt is used as a discount rate for future
cash flows16-*
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MoosaSlides prepared by Afaf MoosaThe cost of capital for
multinationalsThis is likely to be different from that of domestic
firms because multinationals:receive preferential treatmenthave
better access to international capital marketsare more
diversifiedhave volatile cash flows16-*
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MoosaSlides prepared by Afaf MoosaThe APV techniqueThe following
items are taken into account:Remittable cash flowsTax savings and
subsidiesEffect on corporate debt capacityOther cash flows16-*
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MoosaSlides prepared by Afaf MoosaInternational taxationThis is the
taxation of cross-border transactionsDouble taxation arises if
income earned abroad is taxed at home and abroad16-*
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MoosaSlides prepared by Afaf MoosaApproaches to international
taxationClassic approach: income received by each taxable entity is
taxedIntegrated approach: aims at eliminating double taxation
by:taxing undistributed earnings at a higher rate imputation tax
system16-*
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MoosaSlides prepared by Afaf MoosaTypes of taxesCorporate income
taxWithholding taxes Indirect taxesImport dutiesTaxes on FX
gains16-*
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MoosaSlides prepared by Afaf MoosaAvoiding double taxationMany
countries have bilateral tax treaties with other countriesThe OECD
has developed a model tax conventionOne way of avoiding double
taxation is tax credits16-*
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MoosaSlides prepared by Afaf Moosa
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International Finance: An Analytical Approach 3e by Imad A.
MoosaSlides prepared by Afaf MoosaTax havensA tax haven is a place
where foreigners may receive income or own assets without paying
taxes on them16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaCountry riskCountry risk arises
because of the possibility of losses due to country-specific
economic, political and social eventsIt encompasses political risk
and sovereign risk16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaSovereign riskThe possibility of
losses on claims on foreign governments and their agencies16-*
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MoosaSlides prepared by Afaf MoosaPolitical riskThe possibility of
losses due to changes in the rules governing FDI, as well as
adverse political developments16-*
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MoosaSlides prepared by Afaf MoosaPolitical risk:
confiscationConfiscation does not involve proper
compensationExpropriation implies compensation16-*
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MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a
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MoosaSlides prepared by Afaf MoosaIncorporating country risk into
capital budgetingAdjusting expected cash flows or the discount
rateMeasuring the effects of country risk as the value of an
insurance policyUsing option pricing to derive the price of country
risk16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaTransfer pricingThe pricing of
goods and services that are bought and sold (transferred) between
members of a corporate family16-*
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MoosaSlides prepared by Afaf Moosa
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MoosaSlides prepared by Afaf MoosaSetting transfer prices Tax
considerationsGlobal regulationManagement incentives and
performance evaluationMarketing considerations and competition
16-*(cont.)
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MoosaSlides prepared by Afaf MoosaSetting transfer prices
(cont.)Risk and uncertaintyGovernment policiesThe interests of
joint venture partnersThe negotiating power of the subsidiary
16-*
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MoosaSlides prepared by Afaf Moosa
