chapter 18 foreign direct investment and international capital budgeting

Chapter 18

Foreign Direct Investment and International Capital Budgeting

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa

Slides prepared by Afaf Moosa 2

Objectives

• To discuss the characteristics and development of FDI.

• To outline the theories of FDI.• To describe the techniques of

international capital budgeting.• To examine the implications of

taxation, country risk and transfer prices for international capital budgeting.



Definition

• An investment project is classified as direct investment if the investor acquires ‘significant control’ over a firm.



What is ‘Significant Control’ ?

• Ownership of 10-25%• United States, Japan and Australia:

10%• France, Germany and United Kingdom:

higher threshold• Belgium and the Netherlands: no

specific number



Reasons for Interest in FDI

• Rapid growth and changing pattern of FDI

• Concern about causes and consequences of foreign ownership

• FDI channels resources to developing countries

• The role played in transforming ex-communist countries



FDI in the Nineteenth Century

• FDI was prominent, but it mostly took the form of lending by Britain to other countries.



FDI in the Interwar Period

• Foreign investment declined, but direct investment rose.

• Britain lost its status as the major creditor.



FDI in the Post-World War II Period

• FDI started to grow for two reasons: Improvements in transport and

telecommunications Need of European countries and Japan for

US assistance



FDI in the 1960s

• Reversal of trend: Host countries started to show resistance

to US ownership of enterprises Host countries started to recover,

initiating FDI in the United States



FDI in the 1970s

• Lower FDI flows• The United Kingdom appeared as a

major player



FDI in the 1980s

• The United States became a net debtor.

• Japan emerged as a major source of FDI.

• The surge in FDI was due to the globalisation of business.



FDI in the 1990s

• FDI declined in 1990-1992 but rebounded subsequently because: FDI is no longer confined to large firms The sectoral diversity of FDI has

broadened The number of countries involved has

risen



FDI in the 1990s (cont.)

• The decline in the importance of Japan as a source of FDI

• The late 1990s were characterised by the rising popularity of cross-border mergers and acquisitions (M&As)



Inward and Outward FDI

• Inward FDI is when a foreign country invests in the country in question.

• Outward FDI is when the home country invests abroad.



FDI Flows

• Equity capital• Reinvested earnings• Intra-company loans



FDI Stocks

• The value of capital and reserves (including retained earnings) attributable to the parent firm, plus the net indebtedness of its subsidiaries



Australian FDI Flows (USD Billion)

-4

-2

0

2

4

6

8

10

12

14

1990-95 1996 1997 1998 1999 2000 2001

Inflows Ouflows



Australian FDI Stocks (USD Billion)

0

20

40

60

80

100

120

1980 1985 1990 1995 2000 2001

Inward Outward



Cross-Border Mergers and Acquisitions

0

200

400

600

800

1000

1200

1400

1987 1989 1991 1993 1995 1997 1999 2001 2003



Modes of Foreign Market Entry

• Export of the goods produced in the source country

• Licensing a foreign company to use technology

• Foreign distribution of products through a subsidiary

• Foreign (international) production



Choice Between Exporting and FDI

• Profitability • Opportunities for market growth• Production cost levels• Economies of scale



Licensing

• This involves the supply of technology and know-how or the use of a trademark or a patent for a fee.

• It offers one way to generate revenue from foreign markets that are otherwise inaccessible.



Franchising

• Companies with brand-name products move offshore by granting foreigners the exclusive right to sell their products in a designated area.



Types of FDI

• Greenfield investment• Brownfield investment• Mergers and acquisitions• Joint ventures



Choice Between Greenfield Investment and M&As

• Firms with lower R&D intensity, more diversified firms and large multinationals are more inclined to indulge in M&As.

• Inter-country cultural and economic differences reduce the tendency for M&As.



Choice Between Greenfield Investment and M&As (cont.)

• Multinationals with subsidiaries prefer acquisitions.

• The tendency for M&As depends on the supply of target firms.

• Slow growth in an industry encourages M&As.



Theories of FDI

• A number of theories or hypotheses have been put forward to explain FDI.



The Differential Rates of Return Hypothesis

• Capital flows from countries with low rates of return to countries with high rates of return.



The Diversification Hypothesis

• The choice among various projects is determined by expected return and risk.



The Output and Market Size Hypothesis

• The volume of direct investment in one host country depends on sales or market size.



The Industrial Organisation Hypothesis

• A firm indulges in FDI despite inter-country differences because it has some advantages such as brand name, patent, managerial skills, etc.



The Internalisation Hypothesis

• FDI arises from efforts by firms to replace market transactions with internal transactions.



The Location Hypothesis

• FDI exists because of the international immobility of some factors of production.



The Eclectic Theory

• Three conditions must be satisfied if a firm is to engage in FDI: It must have comparative advantages It is better to use rather than lease these

advantages It is more profitable to use these

advantages with factor inputs abroad



The Product Life Cycle Hypothesis

• When a product is standardised, the innovator may decide to invest in developing countries to obtain some advantages, such as cheap labour.



The Oligopolistic Reaction Hypothesis

• FDI by one firm triggers similar investment by other leading firms in an attempt to maintain market share.



The Internal Financing Hypothesis

• FDI is determined by the foreign subsidiaries’ internally generated funds.



The Currency Areas Hypothesis

• Countries with strong currencies tend to be sources of FDI.

• Countries with weak currencies tend to be recipients of FDI.



Diversification with Barriers to Capital Flows

• FDI arises from the desire to diversify through two conditions: Barriers or costs to portfolio flows Multinationals provide diversification

opportunities



Political Stability and Risk

• Lack of political stability discourages FDI inflows.

• Political risk arises because of unexpected modifications of the legal and fiscal framework in the host country.



Tax Policies

• Tax policies affect incentives to engage in FDI because: Tax treatment of income generated

abroad affects the rate of return Tax treatment of income generated at

home affects relative profitability Tax policies affect the relative cost of

capital



Government Regulations

• Regulations may provide incentives (e.g. tax credits and exemptions).

• Regulations may provide disincentives

(e.g. slow processing of required authorisation).



Strategic and Long-term Factors

• The desire to defend foreign markets against competitors

• The desire to gain and maintain a foothold in a protected market

• The need to develop a parent-subsidiary relationship



Strategic and Long-term Factors (cont.)

• The desire to induce the host country into a long-term commitment to a particular type of technology

• The advantage of complementing another type of investment



Strategic and Long-term Factors (cont.)

• The economies of new product development

• Competition for market shares among oligopolists



Evaluating Direct Investment Projects

• Accounting rate of return • Payback period• Net present value (NPV)• Internal rate of return (IRR)



Accounting Rate of Return

• This is the percentage return on capital.

• The method is criticised because: It is based on profit rather than cash

flows. It ignores the size of the project and the

time value of money.



Payback Period

• This measures how quickly the cost is recovered.

• It is based on cash flows.• It ignores the time value of money and

the cash flows arising after the payback period.



Net Present Value

DE

n

tt

t

rDE

Dr

DEE

r

r

CCNPV

1

0 )1(



Internal Rate of Return

0)1(1

0

n

tt

t

r

CC



Adjusting Project Assessment for Risk

• Risk-adjusted discount rate• Risk-adjusted cash flows• Sensitivity analysis



Evaluating FDI Projects

• Two problems: Measurement of cash flows Choice of discount rate



Problems of Cash Flow Measurement

• Cash flows accruing to the parent company and the subsidiary are different because: Different tax rates Restrictions on remittances Excessive remittances Changes in exchange rates



Forecasting Cash Flows

• Demand for the product • Price of the product • Variable costs• Fixed costs• Project lifetime



Forecasting Cash Flows (cont.)

• Salvage value • Remittance restrictions• Tax rates and laws• Exchange rates



The Evaluation Process

• Estimating incremental cash flows • Estimating remittable cash flows in

domestic currency• Incorporating indirect costs and

benefits • Discounting cash flows



The Cost of Capital

• This is the minimum risk-adjusted rate of return required in order for the investment to be accepted.

• It is used as a discount rate for future cash flows.



The Cost of Capital for Multinationals

• This is likely to be different from that of domestic firms because multinationals: Receive preferential treatment Have better access to international capital

markets Are more diversified Have volatile cash flows



The APV Technique

• The following items are taken into account: Remittable cash flows Tax savings and subsidies Effect on corporate debt capacity Other cash flows



International Taxation

• This is the taxation of cross-border transactions.

• Double taxation arises if income earned abroad is taxed at home and abroad.



Approaches to International Taxation

• Classic approach: income received by each taxable entity is taxed.

• Integrated approach: aims at eliminating double taxation by: Taxing undistributed earnings at a higher

rate Imputation tax system



Types of Taxes

• Corporate income tax• Withholding taxes • Indirect taxes• Import duties• Taxes on FX gains



Avoiding Double Taxation

• Many countries have bilateral tax treaties with other countries.

• The OECD has developed a model tax convention.

• One way of avoiding double taxation is tax credits.



Tax Havens

• A tax haven is a place where foreigners may receive income or own assets without paying taxes on them.



Country Risk

• This arises because of the possibility of losses due to country-specific economic, political and social events.

• It encompasses political risk and sovereign risk.



Sovereign Risk

• The possibility of losses on claims on foreign governments and their agencies



Political Risk

• The possibility of losses due to changes in the rules governing FDI, as well as adverse political developments



Political Risk: Confiscation

• Confiscation does not involve proper compensation.

• Expropriation implies compensation.



Incorporating Country Risk into Capital Budgeting

• Adjusting expected cash flows or the discount rate

• Measuring the effects of country risk as the value of an insurance policy

• Using option pricing to derive the price of country risk



Transfer Pricing

• The pricing of goods and services that are bought and sold (transferred) between members of a corporate family



Setting Transfer Prices

• Tax considerations• Global regulation• Management incentives and

performance evaluation• Marketing considerations and

competition



Setting Transfer Prices (cont.)

• Risk and uncertainty• Government policies• The interests of joint venture partners• The negotiating power of the

subsidiary

chapter 18 foreign direct investment and international capital budgeting

Documents

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century fdi

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development of fdi

theories of fdi

major source of fdi

outward fdiinward fdi

fdi rapid growth