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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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Diversification Benefits for
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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Diversification Benefits for
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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Diversification Benefits for
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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Benefits of InternationalDiversification
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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Benefits of InternationalDiversification
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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Benefits of InternationalDiversification
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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Benefits of InternationalDiversification
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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Benefits of InternationalDiversification
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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Benefits of InternationalDiversification
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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Host Government View of DFI
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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Host Government View of DFI
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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Questions and Applications
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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Questions and Applications
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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Questions and Applications
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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Questions and Applications
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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Questions and Applications
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.