MBA (Finance specialisation)

&

MBA – Banking and Finance

(Trimester)

Term VI

Module : – International Financial ManagementUnit III: Financial Management of Multinational Firm

Lesson 3.3 (Foreign Direct Investments )

Foreign Direct InvestmentIntroductionIn imperfect market conditions, multinational corporations (MNCs) taking advantage of their supremacy over the rivals in terms of cost, quality, speed and flexibility vigorously endeavour to expand their operations in different potential countries and for that matter adopt entry strategies based on SWOT analysis and choose a particular mode of entry. Foreign direct investment (FDI), which involves building productive capacity directly in a foreign country, is one of the most important modes of entry into foreign markets. MNCs conduct FDI through joint ventures with foreign firms, cross-border mergers and acquisitions, and formation of new foreign subsidiaries.

Foreign Direct InvestmentIn foreign direct investment, the parent company builds productive capacity in a foreign country. In a cross-border acquisition, a domestic parent acquires the use of an asset in a foreign company. A company can acquire productive capacity in a foreign country in one of the two ways, viz; cross-border acquisition of assets and cross-border acquisition of stock.

Foreign Direct InvestmentCross-border acquisition of assets is the most straightforward method of acquiring productive capacity because only the asset is acquired without the transfer of liabilities to the purchaser. As against this, in a cross-border acquisition of stock, an MNC buys an equity share in a foreign company. In a cross-border merger, two firms pool their assets and liabilities to form a new organization.

Factors affecting growth of FDI

Some of the factors which can explain the growth of FDI in developing countries are as follows:

Product and Market imperfections: MNCs possessing specific intangible capital in the form of trade marks, patents, general marketing skills, and other organizational abilities may be inspired to make overseas investment through new product development and adaptation. At times, MNCs prefer FDI to other modes of entry into overseas markets for protecting misuse of their intangible assets by local firms. Coca-Cola chose FDI as a mode of entry into foreign markets, and set up bottling plants instead of licensing local firms mainly to protect the formula for its famed soft drink. If the company licenses a local firm to produce coke, it has no guarantee that the secrets of the formula will be maintained.

Factors affecting growth of FDI

Market Opportunities: Existence of tremendous market opportunities abroad and fiercely competitive domestic market limiting the growth in demand and the consequent decline in market share may stimulate MNCs to enter into high-potential overseas markets. For instance, many of the developing countries, viz; Argentina, China, Mexico, Chile and Hungary have, of late, been able to attract FDI flows because of existence of attractive markets.

Factors affecting growth of FDI

Trade Barriers: Because of government created restrictions in the form of tariffs, quotas, etc. on imports and exports hindering the free flow of the products across national boundaries, a firm may decide to set up production plants in such countries as means of circumventing the trade barriers.

Factors affecting growth of FDI

Existence of Superior Profits in Overseas Markets: Possibility of making superior earnings in certain overseas market may also allure the MNCs to divert their funds in these markets, However, MNCs are likely to face competitive challenge from the local firms who may prevent a new competitor from taking their business by lowering their prices.

Factors affecting growth of FDI

Imperfect Labour Market: The labour market is the most imperfect among all the factors of production, and labour costs vary widely in different countries. Wage costs in Mexico, Malaysia and India are relatively much lower. Substantially lower labour costs in these countries have attracted many MNCs .

Factors affecting growth of FDI

Access to Inputs: Due to transport costs, MNCs generally avoid importing raw materials from a country where it is not available at a stable price, especially when they plan to sell the finished product to consumers of that very country. Under the circumstances, it would be pertinent to set up production plants in the country where the raw materials are easily available in abundance.

Access to Foreign Technology: MNCs are growingly setting up manufacturing plants or acquiring existing plants in those countries just to learn about the advanced technology and use them to improve their own production process at their subsidiary plants around be globe.

Factors affecting growth of FDI

Behaviour of Foreign Exchange Rate: FDI decisions of MNCs are also influenced by exchange rate movements because cost is one of the key determinants. Firms may be tempted to invest in a country whose currency is perceived by a firm to be undervalued as the initial investment outlay would be low. At times, FDI is driven by the firm's desire to offset the changing demand for its exports owing to exchange rate fluctuations.