Chapter 10

Direct Foreign Investment

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, ( the specifics 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 of the 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 initiating direct foreign investment (DFI); and to illustrate the benefits of international diversification.

Topics for Pre-class Discussion

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.

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 resources or 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 if the MNC plans to sell the finished product back 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 currency appears to depreciate. DFI can also help reduce the MNCs exposure to exchange rate fluctuations.

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 be more appropriate.
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Motives for DFI

Before investing in a foreign country, the potential benefits must be weighed against the costs and risks. Financial market conditions should be considered along with product markets when making DFI decisions. As conditions change over time, some countries may become more attractive targets for DFI, while other countries become less attractive.
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Benefits of International Diversification

The key to international diversification is to select foreign projects whose performance levels 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 a new investment project. Characteristics of Proposed Project If Located in the U.S. the U.K 25% 25% .09 .80 .11 .02

Projects mean expected annual after-tax return Standard deviation of projects return Correlation of projects 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 is expected 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., the portfolio variance for the overall firm
= W 2A

2A +W2B

2B +2

WA W B

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 +W2B 2B +2 WA WB A B

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. 15

Benefits of International Diversification

An MNC may not be insulated from a global crisis, since many countries will be adversely affected. However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the Asian countries might have fared better than if it had focused on one country. Even better would be diversification among the continents.
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Benefits of International Diversification

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 a global 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 International Diversification

An MNC with projects positioned around the world is concerned about the risk and return characteristics of its projects.
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 the graph reflects a specific project that either has been implemented or is being considered.( The return axis may be measured by potential return on assets or return on equity. The risk may be measured by potential fluctuation in the returns generated by each project.)
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Example: Risk- Return Analysis of International Projects

Exhibit 10.1 shows that Project A has the highest expected return of all the projects, yet its risk is also too high. 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 be able to achieve a risk-return tradeoff exhibited by any of the points on the curve in Exhibit 10.1. This curve represents a frontier of efficient project portfolios that exhibit desirable risk-return characteristics, in that no single project could outperform any of these portfolios. As new projects are proposed, the frontier of efficient project portfolios available to Virginia may shift.
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Example: Risk- Return Analysis of International Projects

Exhibit 10.1 Risk-Return Analysis of International Projects
Frontier of Efficient Expected Return Project Portfolios

.. . . . .
B D E F
G Risk

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Benefits of International Diversification

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 International Diversification

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 International Diversification

Exhibit 10.2 Risk-return Advantage of a Diversified MNC
Efficient frontier of project portfolios for multiproduct MNC Expected Return

Efficient frontier of project portfolios for MNC that sells steel to European nations

Risk

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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 majority ownership restrictions, excessive procedure and documentation requirements (red tape), and operational conditions.
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Questions and Applications

*1.

Describe some potential benefits to an MNC as a result of DFI. Elaborate on each type of benefit. 2. Bear Co. and Viking, Inc., are automobile manufacturers that desire to benefit from economies of scale. Bear Co. has decided to establish distributorship subsidiaries in various countries, while Viking, Inc., has decided to establish manufacturing subsidiaries in various countries. Which firm is more likely to benefit from economies of scale? 3. Once an MNC establishes a subsidiary, DFI remains an 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 the Mexican 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 other countries. 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., considered establishing a manufacturing plant in central Asia, which would be used to cover its exports to Japan and China Hong Kong. The cost of labor was very low in Central Asia. On September 11, 2001, the terrorist attacks on the United States caused Ohio to reassess the potential cost savings. Why would the estimated expenses of the plant increase after the 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 each case, 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 the local customers.

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Questions and Applications

a. What comparative advantage does J.C. Penny have when establishing a store in a foreign country, relative to an independent variety store? b. Why might the overall risk of J.C. Penny decrease or increase as a result of its recent global expansion? c. J.C. Penny has been more cautious about entering China. Explain the potential obstacles associated with entering China.
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