IFM11e_ch13

Report
International Financial Management
11th Edition
by Jeff Madura
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Part 4 Long-Term Asset and Liability Management
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13 Direct Foreign Investment
Chapter Objectives
 Describe common motives for initiating foreign
direct investment
 Illustrate the benefits of international
diversification
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Motives for Direct Foreign Investment:
Revenue Related Motives
 Attract new sources of demand
MNCs commonly pursue DFI in countries experiencing economic
growth so that they can benefit from the increased demand for products
and services there.
 Enter profitable markets
When similar industries are generating very high earnings in a particular
country, an MNC may decide to sell its own products in those markets.
 Exploit monopolistic advantages
Firms possessing resources or skills not available to competing firms
may attempt to exploit it internationally.
 React to trade restrictions
MNCs may pursue DFI to circumvent trade barriers.
 Diversity Internationally
By diversifying sales (and possibly even production) internationally, a
firm can make itsnet cash flows less volatile.
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Motives for Direct Foreign Investment:
Cost Related Motives
 Fully benefit from economies of scale
Lower average cost per unit resulting from increased production.
 Use foreign factors of production
Labor and land costs can vary dramatically among countries.
 Use foreign raw materials
Develop the product in the country where the raw materials are
located.
 Use foreign technology
 React to exchange rate movements
When a firm perceives that a foreign currency is undervalued, the
firm may consider DFI in that country, as the initial outlay should
be relatively low.
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Benefits of DFI
 Though disadvantages of DFI may exist, MNCs can compare
benefits of DFI among countries and use DFI to achieve those
benefits (Exhibit 13.1).
 MNCs measure the benefits of DFI by following the steps in
Exhibit 13.2
 MNCs apply a multinational capital budgeting process to compare the
benefits and costs of international projects.
 This capital budgeting analysis commonly involves international
restructuring and an assessment of risk characteristics in the country
where the proposed projects are to be implemented.
 It also requires an assessment of the cost of capital and debt financing
possibilities.
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Exhibit 13.1 Summary of Motives for Direct Foreign
Investment
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Exhibit 13.2 Steps Taken by MNCs to Determine Whether to
Pursue Direct Foreign Investment
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Benefits of International Diversification
 Select foreign projects whose performance levels are
not highly correlated over time. (Exhibit 13.3)
 p2  wA2 A2  wB2 B2  2wA wB A B CORRAB
w  proportionof totalfunds in investments A or B
σ  standarddeviationof returnson investments A or B
CORR  correlation coefficient of returnsA and B
 Perform diversification analysis of international
projects
 Comparing portfolios along the frontier of efficient projects
(See Exhibit 13.4)
 Comparing frontiers among MNCs (See Exhibit 13.5)
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Exhibit 13.3 Evaluation of Proposed Projects in Alternative
Locations
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Exhibit 13.4 Risk-Return Analysis of International Projects
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Exhibit 13.5 Risk-Return Advantage of a Diversified MNC
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Exhibit 13.6 Comparison of Expected Economic Growth
among Countries: Annual Stock Market Return
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Host Government View of DFI
 Incentives to encourage DFI
 The ideal DFI solves problems such as unemployment and lack of
technology without taking business away from local firms.
 Governments are particularly willing to offer incentives for DFI
that will result in the employment of local citizens or an increase
in technology.
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Host Government View of DFI (Cont.)
 Barriers to DFI
a. Protective barriers - agencies may prevent an MNC from
acquiring companies if they believe employees will be laid off.
b. Red tape barriers - procedural and documentation requirements
c. Industry barriers - local firms may have substantial influence on
the government and may use their influence to prevent competition
from MNCs
d. Environmental barriers - building codes, disposal of production
waste materials, and pollution controls.
e. Regulatory barriers - each country enforces its own regulatory
constraints pertaining to taxes, currency convertibility, earnings
remittance, employee rights, and other policies
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Host Government View of DFI (Cont.)
d. Ethical differences - a business practice that is perceived to be
unethical in one country may be ethical in another.
e. Political instability - if a country is susceptible to abrupt changes in
government and political conflicts, the feasibility of DFI may be
dependent on the outcome of those conflicts.
 Government-imposed conditions to engage in DFI
Some governments allow international acquisitions but impose
special requirements on MNCs that desire to acquire a local firm.
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SUMMARY
 MNCs may be motivated to initiate direct foreign investment
in order to attract new sources of demand or to enter markets
where superior profits are possible. These two motives are
normally based on opportunities to generate more revenue in
foreign markets. Other motives for using DFI are typically
related to cost efficiency, such as using foreign factors of
production, raw materials, or technology. In addition MNCs
may engage in DFI to protect their foreign market share, to
react to exchange rate movements, or to avoid trade
restrictions.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)
 International diversification is a common motive for direct
foreign investment. It allows an MNC to reduce its exposure to
domestic economic conditions. In this way, the MNC may be
able to stabilize its cash flows and reduce its risk. Such a goal
is desirable because it may reduce the firm’s cost of financing.
International projects may allow MNCs to achieve lower risk
than is possible from only domestic projects without reducing
their expected returns. International diversification tends to be
better able to reduce risk when the DFI is targeted to countries
whose economies are somewhat unrelated to an MNC’s home
country economy.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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