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    Foreign Portfolio and Direct

    Investment

    INTERNATIOANL FINACIAL

    MANAGEMENT

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    FDI and FPI

    Economic development requires adequate

    capital flows.

    There are two forms of foreign investment inthe host country: Foreign Direct Investment

    (FDI) and Foreign Portfolio Investment (FPI).

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    FDI and FPI

    FDI refers to international investment in which

    the investor obtains a lasting interest in an

    enterprise in another country.

    Foreign Portfolio Investment (FPI) is the

    investment by individuals, firms, or public

    bodies in foreign financial instruments like

    stocks, bonds, other forms of debt.

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    FDI and FPI

    Although FDI, almost by definition, tends to be

    undertaken by multinational corporations, FPI

    comes from more diverse sources, and may

    originate, for example, from a small

    company's pension fund or through mutual

    funds held by individuals.

    Both of them provide capital flows beyond

    what is available through domestic savings.

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    FDI and FPI

    Both serve to boost investment and economic

    activity in the domestic economy, allowing a

    higher level of economic growth than would

    otherwise be possible.

    Both foreign direct and portfolio investment

    bring a range of benefits for economic growth,

    though there may be a marked difference

    between those benefits.

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    FDI

    FDI refers to an investment made by an investorto acquire lasting interest in enterprises operatingoutside of the economy of the investor.

    The investors purpose in making the investmentis to gain an effective voice in the management ofthe enterprise.

    The foreign entity that makes the investment is

    termed the "directinvestor". The enterprise inwhich direct investment is made is referred to asa "directinvestmententerprise".

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    Reasons for FDI

    Resourcesseeking- looking for resources at alower real cost.

    Marketseeking- secure market share and sales

    growth in target foreign market. Efficiency seeking- seeks to establish efficient

    structure through useful factors, cultures,policies, or markets.

    Strategicassetseeking- seeks to acquire assetsin foreign firms that promote corporate long termobjectives.

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    Benefits to Multinational

    Multinationals can get locationadvantages: Locationadvantages are defined as the benefits arising from ahost countrys comparative advantages (like betteraccess to resources or lower real cost from operating in

    a host country). Multinationals can get improved performance:Structuraldiscrepancies are the differences in industrystructure attributes between home and host countries.Examples are when firms invest FDI money to enter

    areas where competition is less intense, whereproducts are in different stages of their life cycle,where market demand is unsaturated, and where thereare differences in market sophistication.

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    Benefits to Multinational

    Multinationals can get very good return on investment(ROI): Companies get Ownership Advantages whichcome from the application of proprietary tangible andintangible assets in the host country. Companies also

    apply their Core Competencies in the host countries.These are competencies that, by definition are rare,inimitable, non-substitutable, and valuable.

    Multinationals can grow by learning: By operating inhost environments multinationals face stimuli that

    force learning and development of capabilities andcompetitive advantages. This learning comes throughexposure to new markets, new practices, customs,ideas, cultures, markets, and competition.

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    FDI ImpactonHost Country

    FDI ImpactonSocial Environment:Among the mostdiscussed social issues are education, cultural impactand social impact.

    FDI Impacton Employment:There are both positiveand negative impacts from FDI. Multinationalcompanies attempt to capitalize on abundant andinexpensive labor, while host countries seek to havefirms develop labor skills and sophistication. Host

    countries often feel that the least desirable jobs aretransplanted from home countries; home countriesoften face the loss of employment as jobs move.

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    FDI ImpactonHost Country

    FDI ImpactonHost Country Business:The

    subsidiarys business is likely to be more

    productive than local competitors. The result

    is uneven competition in the short run, and

    competency building efforts in the longer

    term. It is likely that FDI developed enterprises

    will gradually develop local supportingindustries through supplier relationships in

    the host country.

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    Current Theorieson FDI

    Productlifecycletheory:Ray Vernon asserted thatproduct moves to lower income countries as theymove through their product life cycle. The FDI impact issimilar: FDI flows to developing countries as products

    evolve from being innovative to being mass-produced. Monopolistic Advantage Theory:A multinational has,

    or creates monopolistic advantages that enable it tooperate subsidiaries abroad more profitably than localcompetitors. By creating and defending this

    monopolistic advantage, through FDI, firms extracthigher returns than if they hadnt invested. Advantagescome through superior knowledge and fromeconomies of scale.

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    Current Theorieson FDI

    Internalizationtheory:When external marketsfor supplies, production, or distribution fails toprovide efficiency, companies can invest FDI to

    create their own supply, production, ordistribution streams.

    Eclectic Paradigm Theory:This is also known asthe OLI theory.When firms lever Ownership

    specific advantages (O), Location specificadvantages (L), and Internalization advantages (I)together, they gain advantage from FDI.

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    Foreign Portfolio Investment (FPI)

    FPI is a category of investment instruments

    that are more easily traded, may be less

    permanent, and do not represent a controlling

    stake in an enterprise.

    These include investments via equity

    instruments (stocks) or debt (bonds) of a

    foreign enterprise that does not necessarilyrepresent a long-term interest.

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    FPI

    The difference between FDI and FPI can

    sometimes be difficult to discern, given that

    they may overlap, especially in regard to

    investment in equity.

    Ordinarily, the threshold for FDI is ownership

    of "10 percent or more of the ordinary shares

    or voting power" of a business entity (IMFBalance of Payments Manual, 1993).

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    FDI & FPI Portfolio investment can be much more volatile than

    direct investment.

    Changes in the investment conditions in a country orregion can lead to dramatic swings in portfolioinvestment.

    For a country on the rise, FPI can bring about rapiddevelopment, helping an emerging economy movequickly to take advantage of economic opportunity,creating many new jobs and significant wealth.

    However, when a country's economic situation takes adownturn, sometimes just by failing to meet theexpectations of international investors, the large flowof money into a country can turn into a stampede awayfrom it.

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    FDI & FPI

    Because FDI implies a controlling stake in abusiness, and often connotes ownership ofphysical assets such as a equipment, buildings,

    and real estate, FDI is more difficult to pull outor sell off.

    Consequently, direct investors may be morecommitted to managing their internationalinvestments, and less likely to pull out at thefirst sign of trouble.

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    FPI

    This volatility has effects beyond the specificindustries in which foreign investments havebeen made.

    Because capital flows can also affect theexchange rate of a nation's currency, a quickwithdrawal of investment can lead to rapiddecline in the purchasing power of a currency

    and rapidly rising prices (inflation). Such quickwithdrawals can produce widespread economiccrises.

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    BenefitsofFPI tothehostcountrys

    capitalmarkets

    Foreign portfolio investment increases theliquidity of host countrys capital markets, andcan help develop market efficiency as well.

    Foreign portfolio investment can also bringdiscipline and know-how into the domesticcapital markets. In a deeper, broader market,investors will have greater incentives toexpend resources in researching new oremerging investment opportunities.

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    BenefitsofFPI tothehostcountrys

    capitalmarkets

    Foreign portfolio investment can also help topromote development of equity markets and theshareholders voice in corporate governance.

    Foreign portfolio investors may also help the hostcountrys capital markets by introducing moresophisticated instruments and technology formanaging portfolios. For instance, they may bring

    with them a facility in using futures, options,swaps and other hedging instruments to manageportfolio risk.

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    BenefitsofFPI tothehostcountrys

    capitalmarkets

    Foreign portfolio investment can also help topromote development of equity markets and theshareholders voice in corporate governance.

    Foreign portfolio investors may also help the hostcountrys capital markets by introducing moresophisticated instruments and technology formanaging portfolios. For instance, they may bring

    with them a facility in using futures, options,swaps and other hedging instruments to manageportfolio risk.

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    CAPITAL BUDGETING

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    Political Risk

    Macro risks (all foreign corporations) Micro risks (industry-specific)

    Categories:

    Transfer risk uncertainty regarding cross-border cash flows

    Operational risk

    potential goal conflicts with local governments

    Control risk

    uncertainty regarding expropriations

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    Capital budgeting

    1) Identify initial capital investment.

    2) Estimate future after-tax cash flows. Requires exchange rate forecasts

    foreign tax considerations

    3) Identify appropriate discount rate.

    4) Apply capital budgeting criteria

    (NPV, IRR

    , ...)to evaluate and/or rank projects.

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    Complexities of Budgeting

    for a Foreign Project

    Capital budgeting for a foreign project is considerablymore complex than the domestic case:

    Parent cash flows must be distinguished from project cash

    flows Parent cash flows often depend on the form of financing

    Additional cash flows generated by a new investment inone foreign subsidiary may be in part or in whole takenaway from another subsidiary

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    Complexities

    W

    hose perspective? Parent firm?

    Foreign subsidiary?

    Should the capital budgeting for a multi-national project be

    conducted from the viewpoint of the subsidiary that will

    administer the project, or the parent that will provide most of

    the financing?

    The results may vary with the perspective taken because the netafter-tax cash inflows to the parent can differ substantially from

    those to the subsidiary.

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    Subsidiary versus Parent

    Perspective

    Different perspectives matter:

    when funds cannot be repatriated (temporarily?)

    when considering intra-firm transfer pricing

    intra-firm sales

    royalties, license fees

    when choosing the discount rate

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    Subsidiary versus Parent

    Perspective

    The difference in cash inflows is due to :

    Tax differentials

    What is the tax rate on remitted funds?

    Regulations that restrict remittances

    Excessive remittances

    The parent may charge its subsidiary very highadministrative fees.

    Exchange rate movements

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    Whoseperspective?

    Value of project = NPV of cash flows to investor

    Bottom line: useparent firms perspective

    Start with subsidiarys project cash flows

    Reconsiderthem from parents perspective

    Blocked funds

    Net out intra-firm payments

    Consider spillover effects Cannibalization

    positive effects

    Tax factors

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    How are cash flows repatriated?

    Need to explicitly consider how (whether)

    the parent firm can get the money out

    Dividends (profit repatriation)

    Intra-firm debt

    Intra-firm sales (transfer pricing)

    Royalties, license fees

    Different tax/regulatory status

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    Foreign Subsidiarys Income Statement

    Sales

    Cost of goods sold

    Gross profit

    General & administrative expenses

    License fees

    RoyaltiesManagement fees

    Operating profit (EBITDA)

    Depreciation & amortization

    Earnings before interest & taxes (EBIT)

    Foreign exchange gains (losses)Interest expenses

    Earnings before tax (EBT)

    Corporate income tax

    Net income (NI)

    Dividends

    Retained earnings

    Payments to parent

    for goods or services

    Payments for technology,

    trademarks, copyrights,management or other

    shared services

    Payments of interest

    to parent for intra-

    firm debt

    Distribution of

    dividends to parent

    Before-Tax

    in the

    Host Country

    After-Tax

    in the

    Host Country

    Payment to Parent Company

    Potential Conduits for Moving Funds From

    Subsidiary to Parent

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    Multinational

    Capital Budgeting

    One common method of performing the

    analysis is to estimate the cash flows and

    salvage value to be received by the parent,

    and compute the net present value (NPV) of

    the project.

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    MultinationalCapital Budgeting

    NPV = initial outlayn

    +7cashflow inperiodt

    t=1 (1+

    k)t

    +salvagevalue

    (1+k)n

    k = the required rate of return on the project

    n = project lifetime in terms of periods

    If NPV > 0, the project can be accepted.

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    MultinationalCapital Budgeting

    Example:

    Spartan, Inc. is considering the development

    of a subsidiary in Singapore that willmanufacture and sell tennis rackets locally.

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    Capital Budgeting Analysis: Spartan, Inc.

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    Capital Budgeting Analysis: Spartan, Inc.

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    Factors to Consider in MultinationalCapital Budgeting

    1) Exchange rate fluctuations

    Since it is difficult to accurately forecast

    exchange rates, different scenarios can beconsidered together with their probability of

    occurrence.

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    Analysis Using Different Exchange RateScenarios: Spartan, Inc.

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    Sensitivity of the

    Projects NPV toDifferent ExchangeRate Scenarios:

    Spartan, Inc.

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    Factors to Consider in MultinationalCapital Budgeting

    2) Blocked funds

    Some countries require that the earnings

    generated by the subsidiary be reinvested

    locally for at least a certain period of time

    before they can be remitted to the parent.

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    Capital Budgeting with Blocked Funds: Spartan, Inc.

    Assumethatallfundsare blockeduntilthesubsidiary issold.

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    Factors to Consider in MultinationalCapital Budgeting

    3) Uncertain salvage value

    Since the salvage value typically has a

    significant impact on the projects NPV, the

    MNC may want to compute the break-even

    salvage value.

    4) Impact of project on prevailing cash flows

    The new investment may compete with the

    existing business for the same customers.

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    Factors to Consider in MultinationalCapital Budgeting

    5) Host government incentives

    These should also be incorporated into the analysis.

    6) Real options

    Some projects contain real options for additional businessopportunities.

    The option to defer

    The option to abandon

    The option to alter capacity

    The option to start up or shut down

    The value of such a real option depends on the probability of

    exercising the option and the resulting NPV.

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    Summary

    Multinational capital budgeting is

    conceptually similar to standard capital

    budgeting

    But:

    parent/subsidiary complications

    cash flow projections more complicated

    Additional sources of risk

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    Country Risk Analysis

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    Why Country Risk Analysis Is Important

    Country risk represents the potentiallyadverse impact of a countrys environment on

    an MNCs cash flows.

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    Country risk analysis can be used:

    to monitor countries where the MNC is

    currently doing business; as a screening device to avoid conducting

    business in countries with excessive risk; and

    to revise its investment or financing decisions

    in light of recent events.

    Why Country Risk Analysis Is Important

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    Political Risk Factors

    Attitude of consumers in the host country

    Some consumers are very loyal to locally

    manufactured products. Actions of host government

    The host government may impose special

    requirements or taxes, restrict fund transfers,

    and subsidize local firms. MNCs can also behurt by a lack of restrictions, such as failure to

    enforce copyright laws.

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    Political Risk Factors

    Blockage of fund transfers

    If fund transfers are blocked, subsidiaries will

    have to undertake projects that may not beoptimal for the MNC.

    Currency inconvertibility

    The MNC parent may need to exchange

    earnings for goods if the foreign currency

    cannot be changed into other currencies.

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    War

    Internal and external battles, or even the

    threat of war, can have devastating effects. Bureaucracy

    Bureaucracy can complicate businesses.

    Corruption Corruption can increase the cost of conducting

    business or reduce revenue.

    Political Risk Factors

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    Corruption Index Ratings for Selected CountriesMaximumrating=10.Highratingsindicatelow corruption.

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    Financial Risk Factors

    Indicators of economic growth

    The current and potential state of a countrys

    economy is important since a recession canseverely reduce demand.

    A countrys economic growth is dependent on

    several financial factors - interest rates,

    exchange rates, inflation, etc.

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    Types of Country Risk Assessment

    A macroassessment of country risk is an overall

    risk assessment of a country without considering

    the MNCs business.

    A microassessment of country risk is the risk

    assessment of a country with respect to the

    MNCs type of business.

    The overall assessment thus consists ofmacropolitical risk, macrofinancial risk,

    micropolitical risk, and microfinancial risk.

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    Note that there is clearly a degree of

    subjectivity in:

    identifying the relevant political and financialfactors,

    determining the relative importance of each

    factor, and

    predicting the values of factors that cannot bemeasured objectively.

    Types of Country Risk Assessment

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    Techniques ofAssessing Country Risk

    The checklist approach involves rating and

    weighting all the macro and micro political

    and financial factors to derive an overall

    assessment of country risk.

    The Delphi technique involves collecting

    various independent opinions and then

    averaging and measuring the dispersion ofthose opinions.

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    Techniques ofAssessing Country Risk

    Quantitative analysis techniques like

    regression analysis can be applied to historical

    data to assess the sensitivity of the business

    to various risk factors.

    Inspection visits involve traveling to a country

    and meeting with government officials, firm

    executives, and consumers to clarifyuncertainties.

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    Often, firms use a variety of techniques for

    making country risk assessments.

    For example, they may use the checklist

    approach to develop an overall country risk

    rating, and some of the other techniques to

    assign ratings to the factors.

    Techniques ofAssessing Country Risk

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    Measuring Country Risk

    The checklist approach involves:

    Assigning values and weights to political and

    financial risk factors,

    Multiplying the factor values with their weights,

    and summing up to give the political and

    financial risk ratings,

    Assigning weights to the risk ratings, and Multiplying the ratings with their weights, and

    summing up to give the country risk rating.

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    Example:Determining the Overall Country Risk Rating

    E l

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    Example:Derivation of the Overall Country Risk Rating

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    The procedures for quantifying country risk

    will vary with the assessor, the country

    being assessed, as well as the type ofoperations being planned.

    Firms use country risk ratings when

    screening potential projects, and when

    monitoring existing projects.

    Measuring Country Risk

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    Comparing Risk RatingsAmong Countries

    One approach to comparing political andfinancial ratings among countries is theforeign investment risk matrix (FIRM).

    The matrix displays financial (or economic)and political risk by intervals ranging frompoor to good.

    Each country can be positioned on thematrix based on its political and financialratings.

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    Incorporating Country Risk in CapitalBudgeting

    If the risk rating of a country is acceptable, the

    projects related to that country deserve

    further consideration.

    Country risk can be incorporated into the

    capital budgeting analysis of a proposed

    project either by adjusting the discount rate or

    by adjusting the estimated cash flows.

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    Adjustment of the discount rate

    The higher the perceived risk, the higher thediscount rate that should be applied to the

    projects cash flows.

    Adjustment of the estimated cash flows

    By estimating how the cash flows could be

    affected by each form of risk, the MNC candetermine the probability distribution of thenet present value of the project.

    Incorporating Country Risk in CapitalBudgeting

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    Applications ofCountry Risk Analysis

    As a result of the crisis that culminated in the

    GulfWar in 1991, many MNCs reassessed

    their exposure to country risk and revised

    their operations accordingly.

    The 199798 Asian crisis caused MNCs to

    realize that they had underestimated the

    potential financial problems that could occurin the high-growth Asian countries.

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    Reducing Exposureto Host Government Takeovers

    The potential benefits of DFI can be offset by

    country risk, the most severe of which is a

    host government takeover.

    To reduce the chance of a takeover by the host

    government, firms often:

    Use a short-term horizon

    This technique concentrates on recovering cash

    flow quickly.

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    Reducing Exposureto Host Government Takeovers

    Rely on unique supplies or technology

    In this way, the host government will not be able

    to take over and operate the subsidiary

    successfully.

    Hire local labor

    The local employees can apply pressure on their

    government if they are affected by the takeover.

    d

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    Borrow local funds

    The local banks can apply pressure on their

    government if they are affected by the takeover.

    Purchase insurance

    Investment guarantee programs offered by the

    home country, host country, or an international

    agency insure to some extent various forms ofcountry risk.

    Reducing Exposureto Host Government Takeovers

    d i

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    Use project finance

    Project finance deals are heavily financed with

    credit, thus limiting the MNCs exposure. The

    loans are secured by the projects future revenuesand are non recourse. A bank may guarantee the

    payments to the MNC.

    Reducing Exposureto Host Government Takeovers