THEORETICAL FRAMEWORK OF FOREIGN DIRECT INVESTMENT

THEORIES OF FDI

There are a number of theories explaining FDI. Except for the MacDougall-Kemp
hypothesis, FDI theories are primarily based on imperfect market conditions. A few
among them are based on imperfect capital market. The others take non-economic factors
into account. Still others explain the emergence of MNCs exclusively among developing
countries.

MacDougall-Kemp Hypothesis

One of the earliest theories was developed by G.D.A. MacDougall (1958) and
subsequently elaborated by M.C. Kemp (1964). Assuming a two-country model – one
being the investing country and the other being the host country – and the price of capital
being equal to its marginal productivity, they explain that capital moves freely from a
capital abundant country to a capital scarce country and in this way the marginal
productivity of capital tends to equalize between the two countries. This leads to
improvement in efficiency in the use of resources that leads ultimately to an increase in
welfare. Despite the fact that the output in the investing country decreases in the wake of
foreign investment outflow, national income does not fall insofar as the country receives
returns on capital invested abroad, which is equivalent to marginal productivity of capital
times the amount of foreign investment. So long as the income from foreign investment is
greater than the loss of output, the investing country continues to invest abroad because it
enjoys greater national income than prior to foreign investment. The host country too
witnesses increase in national income as a sequel to greater magnitude of investment,
which is not possible in the absence of foreign investment inflow.

Industrial Organisation Theory

The industrial organization theory is based on an oligopolistic or imperfect market in

which the investing firm operates. Market imperfections arise in many cases, such as
product differentiation, marketing skills, proprietary technology, managerial skills, better
access to capital, economies of scale, government-imposed market distortions, and so on.
Such advantages confer on MNCs an edge over their competitors in foreign locations and
thus, help compensate the additional cost of operating in an unfamiliar environment.

One of the earliest theories based on the assumptions of an imperfect market was
propounded by Stephen Hymer (1976). To Hymer, a multinational firm is a typical
oligopolistic firm that possesses some sort of superiority and that looks for control in an
imperfect market with a view to maximizing profits. Despite the fact that the international
firm is posted disadvantageously in a foreign host country where it has not intimate
knowledge of language, culture, legal systems and consumers’ preference, it possesses
certain specific advantages that outweigh the disadvantages. The firm-specific advantages
in Hymer’s view are mainly the technological advantages that help the firm to produce a
new product different from the existing one. It is in fact related to the possession of

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knowledge, which helps in developing special marketing skills, superior organizational
and management set-up, and improved processing. What is significant in this theory is
that these advantages are transmitted more effectively from one unit to the other
irrespective of their geographical distance. Since the market is imperfect, rival firms do
not avail of the technological advantage. International firm harvests huge profits. Graham
and Krugman (1989) found empirically that it was the technological advantage possessed
by European firms that had led them to invest in the USA. Caves (1971) feels that firm-
specific advantages are transmitted more effectively if the firm participates effectively in
the production in the host country than through other ways such as export or licensing
agreements.

Location-specific Theory

Hood and Young (1979) stress upon the location-specific advantages. They argue that
since real wage cost varies among countries, firms with low cost technology move to low
wage countries. Again, in some countries, trade barriers are created to restrict import.
MNCs invest in such countries in order to start manufacturing there and evade trade
barriers. Sometimes it is the availability of cheap and abundant raw material that
encourages the MNCs to invest in the county with abundant raw material.

Product Cycle Theory

Hymer explained “why” foreign investment takes place. Hood and Young explained
“where” foreign investment takes place. It was Raymond Vernon (1966) who added
“when” to “why” and “where”, based on data obtained from US corporate activities.
Reymond Vernon’s theory is known as the product cycle theory.

Vernon feels that most products follow a life cycle that is divided into three
stages. The first is known as the “innovation” stage. In order to compete with other firms
and to have a lead in the market, the firm innovates a product with the help of research
and development. The product is manufactured in the home country primarily to meet the
domestic demand, but a portion of the output is also exported to other developed
countries. The quality of the product, and not the price, forms the basis of demand
because the demand is price-inelastic at this stage.

The second stage is known as “maturing product” state. At this stage, the demand
for the new product in other developed countries grows substantially and it turns price-
elastic. Rival firms in the host country itself begin to appear at this stage to supply similar
products at a lower price owing to lower distribution cost, whereas the product of the
innovator is often costlier as it involves the transportation cost and tariff that is imposed
by the importing government. Thus in order to compete with rival firms, the innovator
decides to set up a production unit in the host country itself, which would eliminate
transportation cost and tariff. This leads to internationalization of production. The
imposition of tariff in the host country encouraging foreign direct investment is
confirmed by Uzawa and Hamada, but they feel that entry of foreign capital in protected
industry reduces welfare in the host country (Kojima, 1978).

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 In the final or “standardized product” stage, a standardized product and its
production techniques are not longer the exclusive possession o the innovating firm, rival
firms from the home country itself, or from some other developed countries, put stiff
competition. This is not unusual because the follow-the-leader theory developed by
Knickerboker (1973) suggests that there is a tendency among followers to snatch the
benefits of international production from the innovator. At this stage, price
competitiveness becomes even more important; and in view of this fact, the innovator
shifts the production to a low cost location, preferably a developing country where labour
is cheap. The product manufactured in a low cost location is exported back to home
country or to other developed countries.

Literature on the subject identifies one more stage in the product’s life cycle. It is
known as “dematuring” stage, when development in technology or in the consumers’
preference breaks down product standardization. Sophisticated models of the product are
manufactured again in technology advanced, high income countries so that the firm can
have a close linkage with consumers’ tastes and with the basic infrastructure required for
production. Cheap labour does not matter much at this stag as sophisticated models
involve a capital intensive mode of production. Globerman (1986) has explained the four
stages with a simple example of television set that was first produced in the United States
of America and then in other advanced countries. Technology became standardized.
Production became concentrated in Japan owing to the cheap labour cost. Lastly, the
dematuring stage appeared when sophisticated models were developed and produced in
the USA itself.

The product cycle theory clearly explain the early post-Second World War
expansion of US firms in other countries. But with changes in the international
environment, different stages of the product life cycle did not necessarily follow in the
same way. Vernon (1979) himself has pointed out this limitation in his later writing,
showing how in the second stage itself firms were found moving to the developing world
to reap the advantages of cheap labour. This was possible with the narrowing of the
information gap.

Again, the assumptions of the theory that the “export threat” causes a firm to set
up a subsidiary in that country are not always true. If this is true, all US firms should have
set subsidiaries abroad in countries to which they had been exporting (Bhagwati, 1972).
Yet again, development in the second stage and in the third stage is contradictory in the
sense that the former is anti trade oriented vis-à-vis the latter, which is trade-oriented. In
fact, it is this difference that characterizes US firms and differentiates them from the
Japanese ones (Kojima, 1985).

Internalization Approach

Buckley and Casson (1976) too assume market imperfection, but imperfection, in their
view, is related to the transaction cost that is involved in the intra-firm transfer of
intermediate products such as knowledge or expertise. In an international firm,

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technology developed at one unit is normally passed on to other units free of charge. This
means that the transaction cost in respect of intra-firm transfer of technology is almost
zero, whereas such costs in respect of technology transfer to other firms are usually
exorbitantly high putting those firms at a disadvantage. Coase (1937) too believes that
MNCs bypass the regular market and use internal prices to overcome the excessive
transaction cost of an outside market. Thus, it is the internationalization benefit
manifesting in cost-free intra-firm flow of technology or any other knowledge that
motivates a firm to go international. It can be said that the views of Burckley and Casson
are more or less in common with the contents of the appropriability approach of Magee
(1979) that emphasizes on potential returns from technology creation as a prime mover
behind internationalization of firms.

There are, of course, critics who argue that intra-firm transaction cost may not
necessarily be low. If subsidiaries are located in an unfamiliar or uncongenial
environment, the transaction cost is generally high. Kogut and Parkinson (1993) are of
the view that if the transfer of intermediate goods involves substantial modification of
well established practice, transaction cost is very large. Franke, Hofstede, and Bond
(1991) opine that if the cultural differences between the home country and the host
country are wide, the internalization process will be a costly affair.

Again, the internationalization theory, say Rugman (1986), is a general theory

explaining FDI and so it lacks empirical content. However, in a subsequent study, he feels
that with a precise specification of some additional conditions successful testing is
possible. Buckley (1988) himself is suspicious of the very limitation, but is hopeful of
getting satisfactory results from a rigorous and precise test.

Eclectic Paradigm

Dunning’s eclectic paradigm is a combination of the major imperfect market-based

theories of FDI, that is, industrial organization theory, internalization theory and location
theory. It postulates that, at any given time, the stock of foreign assets owned by a
multinational firm is determined by a combination of firm specific or ownership
advantage (O), the extent of location bound endowments (L), and the extent to which
these advantages are marketed within the various units of the firm (I). Dunning is
conscious that configuration of the O-L-I advantages varies from one country to the other
and from one activity to the other. Foreign investment will be greater where the
configuration is more pronounced.

Again, he introduces a “dynamised add-on” variable to his theory. This is nothing

but a variable of strategic change, which may be either autonomous or a strategy induced
change. International production during a particular period would be the sum of the
strategic responses of the firm to the past configuration of O-L-I and to changes in such
configuration as a sequel to exogenous and endogenous changes in environment. The
example of autonomous change in strategy may be that a firm makes foreign investment
more in innovatory activities because of greater O-advantage, or it invests more in a
particular country because of L-advantage or it adopts a different marketing strategy

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depending upon the greater amount of I-advantage. Similarly, the strategy induced
change may be evident from the fact that a market seeing investment has a different O-L-
I configuration from that of a resource based investment. And ultimately, it is the varying
configuration that shapes the direction and the pattern of FDI (Dunning, 1980, 1993).

The eclectic approach thus, has wider coverage. It has also been empirically tested
by Dunning himself with satisfactory results.

Currency based Approaches

The currency based theories are normally based on imperfect foreign exchange and
capital market. One such theory has been developed by Aliber (1971). He postulates that
internationalization of firms can best be explained in terms of the relative strength of
different currencies. Firms from a strong-currency country move out to a weak-currency
country. In a weak-currency country, the income stream is fraught with greater exchange
risk. As a result, the income of a strong-currency country firm is capitalized at a higher
rate. In other words, such a firm is able to acquire a large segment of income generation
in the weak-currency country corporate sector.

The merits of Aliber’s hypothesis lie in the fact that it has stood up to empirical
testing. FDI is the United States of America, Canada and United Kingdom has been found
to be consistent with the hypothesis. However, the theory fails to explain why there is
FDI in the same currency area.

Another theory based on the strength of currency has been developed by Kenneth
Froot and Jeremy Stein (1989). The view is that depreciation in the real value of currency
of a country lowers the wealth of domestic residents vis-à-vis the wealth of foreign
residents. As a result, it is cheaper for foreign firms to acquire assets of domestic firms.
The authors have found that this factor has been one of the determinants of foreign
investment in the United States of America.

Yet another theory in this context has been propounded by Richard Caves (1988)
in one of his later writings. Caves mentions a couple of channels through which exchange
rate influences FDI. First, changes in exchange rate influence the cost and revenue stream
of firm. If the domestic currency depreciates, the import bill will inflate, diminishing in
turn the net income. But, if export expands in the wake of currency depreciation, income
will rise. Secondly, exchange rate changes influence FDI by giving rise to capital gains.
Depreciation in the value of currency, which is expected to be reversed in the near future,
will lead to capital gains following appreciation. In lure of capital gains, foreign capital
will flow in. This theory has been tested empirically by Caves himself, who finds a
negative correlation between the level of exchange rate and the level of FDI in the USA.

Politico-economic Theories

The politico-economic theories concentrate on political risk. Political stability in the host
countries leads to foreign investment therein (Fatehi-Sedah and Safizedah, 1989).

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Similarly, political instability in the home country encourages investment in foreign
countries (Tallman, 1988). However, Schneider and Frey (1985) believe that the theory
underlying the political determinants of FDI is less well developed than those involving
economic determinants. The political factors are only additive ones influencing foreign
investment.

Modified Theories for Third World Firms

The theories discussed above also apply to international firms headquartered in

developing countries, but they need some modifications. These firms have long been
importing technology from industrialized countries. But since imported technology is
mainly designed to cope with a large market, firms export a part of their output after
meeting the domestic demand. The products become gradually mature and then the firms
set up units in the product importing countries. But it is different from the product cycle
theory insofar as the firms do not necessarily innovate the product; rather they modify the
product to suit the consumers’ needs in different contractual. The modification is of
scaling-up kind when it concerns the consumers in the developed countries. For the low
income consumers, it is a scaling-down modification. However, it cannot be denied that
modification of these types confers upon the firms a sort of firm-specific advantage
(Sharan, 1985). Winlee Ting (1982) cites an example of a Taiwanese firm manufacturing
pressure cookers and table fans. The firm modified the imported technology and set up
units not only in the developing countries but also in the country from where it had
originally imported the technology.

Again, the firms in developing countries possess a pool of cheap labour that
accompanies the investment. On the other hand, the developing host country possesses, in
some cases, abundance of natural resources, which attracts investment from other
developing countries. This is very much in common with the locational theory of FDI
Joint
discussed above. Thus, the theories Venture
discussed so far applies also to MNCs of the
developing world.

India’s leading tractor maker Mahindra & Mahindra’s

American arm, Mahindra’s USA Inc, has decided to set
up an assembly unit in Canada to locally produce and
market a range of low-horsepower cab tractors, with
features like AC, heater, personal stereo and even a sun-
roof.

Venture is expected to be in placed by mid-2005.

The firm will also source cab tractors from Japan’s

Mitsubishi and Tong Yang of South Korea, and market
them in Canada under the Mahindra badge. The tractors
will all be in the 0-100hp segment, which accounts for a 6
chunk of US and Canadian markets.
 Riding on growing demand for its tractors,
Mahindra USA had posted a 20% jump in turnover
in 2004 at $125 million.

In response to rising US demand, Mahindra USA

had opened a second assembly plant and
distribution centre in Georgia.
BENEFITS AND COSTS OF FDI

When direct investment flows from one country to another, it creates benefits both for the
home country and the host country. At the same time, it involves some costs too. Thus,
Source: Adapted from TOI report.
when a firm decides to make FDI, it takes into consideration the benefits and costs to be
accrued, not only to its home country but also to the host country. The host country
perspective is no less significant, because cooperation from the host government depends
upon the benefits derived by the host country.

In the present section, the benefits and costs of FDI are mentioned from the point
of view of the home country as well as the host country. Since the host country
perspective is more sensitive, it will be discussed first.

Benefits to the Host Country

Availability of Scarce Factors of Production: FDI helps attain a proper balance

between different factors of production through the supply of scarce factors and fosters
the pace of economic development. FDI brings in capital and supplements the domestic
capital. This is a significant contribution where the domestic savings rate is too low to
match the warranted rate of investment. FDI brings in scarce foreign exchange, which
activates the domestic savings that would not have been put into investment in the
absence of foreign exchange availability. It happens when the investment outlay
possesses a foreign exchange component and in absence of foreign exchange, domestic
savings remain idle. It also happens when local investors are afraid of the large risk
involved in the investment project. In case of FDI, foreign investors share the risk and the
investment project is implemented.

One can say that a country can get scarce foreign exchange also through foreign
borrowing and other forms of investment. But FDI is superior to all of them. It is because
FDI, which takes a longer-term view of the market, is more stable than non-FDI flows.
Statistics reveal that the coefficient of variation of real FDI was on an average 0.94 and
0.63, respectively, during 1980-1989 and 1990-1997, compared to 1.96 and 1.76 for non-
FDI flows during the corresponding period (United Nations, 1999). Moreover, it does not
create debt. Profit is repatriated only when it actually exists.

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 Sometimes FDI is accompanied by labour force that performs jobs that the local
labour force is either not willing to do or is incapable of doing on account of lack of
desired skill. Besides, the foreign labour force infuses non-traditional mental attitudes
among the local labour force.

Besides, foreign investors make available raw material and improved technology.
Raw material is normally not a very important consideration for the host country, but this
factor becomes significant when the question of some vital raw material is concerned. At
the same time, host countries often encourage FDI inflows because they procure
improved technology; and more importantly, an ongoing access to continued research and
development programmes of the investing country. Statistics reveal that over 90 per cent
of the R&D activities giving rise to the creation of new product and process technology
are concentrated in seven industrialized countries. Other countries reap the benefit from
these innovative activities when they are transferred to them in the form of FDI through
MNCs. The transfer takes two forms – one is internalized to the affiliates under the same
ownership and control and the other is externalized to other firms in form of franchises,
licenses, sub-contracting and so on. Externalized transfer is found in cases where
technology is simple and secrecy considerations are not very important, but it is often
costly. Internalized transfer is often cheaper and can be made at different levels of
operation. Whatever may be mode of transfer, it benefits the recipient. In the short-term,
the benefit manifests in the form of increased productivity, new products and lower costs.
In the long term, it depends on how much the recipient learns from the technology and is
able to deepen and develop its own capabilities. For the economy as a whole, the benefits
also include the diffusion of technology and its spillovers to other firms.

As regards diffusion, it depends on how intense the linkages are in the host
country. Since MNCs prefer to establish linkages with foreign firms, local linkages are
often poor. However, such trends are gradually changing. Mani (1999) points out the
Japanese MNCs have been transplanting their traditional keirestsu links from their home
country to host countries. Again, Kumar (1998) found in the case of US and Japanese
MNCs operating in a sample of 74 host countries that the affiliate R&D intensity was
positively and significantly related to the scale of R&D activity and the availability of
scientists and engineers in the host country.

Improvement in the Balance of Payments: FDI helps improve the balance of payments
of the host county. The inflow of investment is credited to the capital account. At the
same time, the current account improves because FDI helps either import substitution or
export promotion. The host country is able to produce items that were being imported
earlier. FDI is able to augment export because foreign investors bring in the knowledge of
exporting mechanics and of foreign markets. They bring in improved technology to
produce goods of international standards and at a lower cost. They posses a world-
reputed brand name, which is helpful in promoting export. They are also more capable of
availing export credits from the cheapest source in the international financial market. In
the United States of America, for example, MNCs – both local and foreign combined –
accounted for three-fourths of the total export in 1996. They have done well in the export
of natural resources, processed agricultural products, and of services, but they have done

8
far better in the export of manufactured goods. In fact, they pursue the export activities
not only in the existing pattern of comparative advantage, but more importantly they
exploit this advantage (Helleiner, 1973). These MNCs operate in low technology
activities and derive competitive strength in export on the basis of cheap labour or cheap
raw material. In case of medium and high technology activities, they are able to export
well on the basis of their vertical set-up or because of their involvement in large scale
processing of natural resources. They bring in dynamisms in the sense that they move on
to the next level of technological complexity. In a primary goods exporting country,
dynamism means launching of simple manufactured products. In case of countries with
simple manufactured exports, they move to higher value added products. An UNCTAD
study shows a positive correlation between FDI and export dynamism in the developing
world (United Nations, 1999).

Building of Economic and Social Infrastructure: When foreign investors invest in

sectors such as basic economic infrastructure, social infrastructure, financial markets, and
marketing system, the host county is able to develop a support system that it required for
repaid industrialization. Even if there is no investment in these sectors, they very
presence of foreign investors in the host country creates a multiplier effect. A support
system develops automatically.

Fostering of Economic Linkages: Foreign firms have forward and backward linkages.
They make demand for various inputs, which in turn helps develop input supplying
industries. They employ labour force, which helps raise the income of employed people,
which helps raise the income of employed people, which in turn raises the demand and
industrial production in the country. In all, the total investment in the host country
increases by more than the amount of FDI. This is nothing but the “crowding-in effect” of
FDI. An empirical study of Borensztein et al (1995) shows that the crowding-in effect of
FDI is very common. Table 1 shows a broad framework of the relationship between
foreign firms and local firms.

Strengthening of Government Budget: Foreign firms are a source of tax income for
the government. They pay not only income tax but also the tariff on their import. At the
same time they help reduce governmental expenditure requirements through
supplementing the government’s investment activities. All this eases the burden on the
budget.

Benefits for Home Country

FDI benefits the home country too. The country gets the supply of necessary raw material
if the investor makes investments in the exploration of a particular raw material. The
balance of payments improves insofar as the parent company gets dividend, technical
service fees, and other payments. It is also because of the rising export of the parent
company to the subsidiary. If FDI takes place in order to develop a vertical set-up abroad,
the export is quite significant. When persons accompany the investment, it results in
greater employment of the nationals. The parent company gains access to new financial
markets through investment abroad.

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 Table 1: Backward Linkage and Other Relationships between Foreign Affiliates and Local Enterprises and Organizations

Source: UNCTAD
Relationship of foreign affiliate to local enterprise Relationship of foreign affiliate
From Backward (sourcing) Forward (distribution) Horizontal (co-operation to non-business institution
in production)
“Pure” market • “Off-the-shell” • “Off-the-shell” sales
transaction purchases
Short-term linkage • Once-for-all or • Once-for-all or
intermittent purchases intermittent sales (on
(on contract) contract)
Longer-term • Longer-term • Longer-term • Joint projects with • R&D contracts with local
linkage (contractual) (contractual) competing domestic institutions such as
arrangement for the relationship with local firm universities and research
procurement of inputs distributor or and research centres
for further processing
• Subcontracting of the • Training progammes for
production of final or firms by universities
intermediate products • Outsourcing from
domestic firms to • Traineeships for students
foreign affiliates
Equity relationship • Joint venture with • Joint venture with • Horizontal joint • Joint public-private R&D
• Establishment of new distributor or end- venture centres/training
supplier-affiliate (by customer • Establishment of new centres/universities
existing foreign • Establishment of new affiliate (by existing
affiliate) distribution affiliate foreign affiliate) for
(by existing foreign the production of
affiliate) same goods and
services as it produces
“Spillover” • Demonstration effects in unrelated firms
- Spillover on processes (incl. technology)
- Spillover on product design
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- Spillover on formal and on tacit skills (shopfloor and managerial)
• Effect due to mobility of trained human resources
Competition effects
 Moreover, the government of the home country generates revenue by taxing the
dividend and other earnings of the parent company. There is also revenue from tariff on
imports of the parent company from its subsidiary abroad. Again, since FDI is a
complement to foreign and, it helps develop a closer political tie between the home
country and the host country, which is beneficial for both countries.

Cost to the Host Country

It is a fact that the inflow of foreign investment helps improve the balance of payments,
but the outflow on account of import and the payments of dividend, technical service
fees, royalty and so on deteriorates the balance of payments. There is evidence to prove
that such outflows have exceeded the investment inflows in some of the years in India
(Sharan, 1978). This is not only the case of balance of payments. Raw materials are
exploited keeping in view the interest on the home country, which sometimes mars the
interest of the host country. Again, the parent company supplies the technology to the
subsidiary, but normally does not disseminate it to the host market. The result is that the
host country remains dependent on the home country for the technology, which is often
received at an exorbitant price. Sometimes the technology is inappropriate for the local
environment and in that case, the loss to the host country is large.

As far as employment of the locals is concerned, MNCs normally show reluctance

to train local people. Technology is normally capital intensive, which does not assure
larger employment.

Sometimes, manufacturing by the foreign investors does not abide by the

pollution norms, the norms regarding optimal use of natural resources, or the norms
regarding location of industries. All this goes against the interest of the host country.

Foreign investors are generally more powerful. Domestic industrialists do not

compare with then, with the result that the domestic industry fails to grow. This is nothing
but the “crowding-out” effect of FDI. The study of Kumar and Pradhan (2002) finds that
in 29 out of 83 cases, there was a clear-cut crowding-out effect. Foreign companies in
such cases, charge higher prices for the product in view of their oligopolistic position in
the market. Higher prices hamper the interest of the consumers as well as lead to
inflationary pressure. Foreign companies infuse foreign culture into the industrial set-up
and also in the society. Sometimes, they are so powerful that they are able to subvert the
government.
Cost to Home Country

The cost accruing to the home country is only little. However, it cannot be denied that
investments abroad takes away capital, skilled manpower, and managerial professionals
from the country. Sometimes the outflow of these factors of production is so large that it
hampers the home country’s interest.

The MNCs operate in different countries in order to maximize their overall profit.
To this end, they adopt various techniques that may not be in the interest of the host

11
country. This leads to a tussle between the host government and the home government,
leading to deterioration bilateral relations.

Thus, FDI is not an unmixed blessing. It does posses bright features, but at the
same time, it has dark sport too. Thus, global benefit can be achieved only if it is
carefully handled.

M&As AND VALUE OF THE FIRM

M&A is a gainful strategy only when the value of the combined firm is greater than the
sum of the value of the two firms computed individually in absence of a merger. In form
of an equation,

Gain = VAB – (VA + VB) (1)

However, the gain so derived has to be compared with the cost of M&A, which is
arrived at after deducting the value of the target firm from the price that the acquiring
firm pays to the target company. This means that the net gain from M&A accruing to the
acquiring firm exists only when:

[VAB – (VA + VB)] > (Price – VB] (2)

Thus, in this context, it is significant to know what price the acquiring firm should pay to
the target firm for acquisition and what would be the impact of the changes in price on
the post-merger value of the firm. The price is known as the consideration value fixed
within the two extremes. One is the floor price for the package, any price below which is
not acceptable by the target company. It is basically the market value of the shares of the
target company. For example, if Firm A acquires Firm B and if the market value of Firm
B’s share is $15, the consideration value must be least be $15. In practice, it is more than
$15, as the premium will attract Firm B for acquisition.

However, it does not mean that the amount of premium will swell infinitely. If it
moves up beyond a certain limit, the value of the acquiring firm will reduce and the very
objective of the acquiring firm behind the merger will be marred. This limit is known as
the ceiling price, where the EPS of the acquiring firm in the post-merger period is equal
to that in the pre-merger period. In other words, the ceiling price would be equal to the
product of the EPS of the target firm and the P/E ratio of the acquiring firm.

Suppose the financial data of the two firms is as follows:

Firm A Firm B

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Present earnings ($) 20,000.00 8,000.00
Shares (no.) 5,000.00 3,000.00
EPS ($) 4.00 2.67
Market value of shares ($) 32.00 16.00
Price-earning ratio 8.00 6.00

At the floor price, the value of Firm B in the post-merger period will be the same
as during the pre-merger period. The owners of Firm B will get 16/32 x 3,000 or 0.5
share in Firm A for one share in Firm B. Thus, the wealth of Firm B in the post-merger
period will be $32 x 1500 shares or $48,000, which is equal to $16 x 3,000 shares during
the pre-merger period.

At this floor price paid, the EPS of Firm A after the merger will increase to
$(20,000 + 8,000) / (5,000 + 1,500 shares) or to $4.31. Assuming a price-earning ratio of
8.0, the value of one share of Firm A after the merger will be $4.31 x 8.0 or $34.48 and
the value of one the merged firm will be $34.48 x 6,500 shares = $224,120, which is
higher than the sum of the value of the two firms in the pre-merger period. Using
equation 1, the net gain from merger will be:

${224,120 – (160,000 + 48,000) } – (48,000 – 48,000)

= $16,120.

The greater the price than the floor price, the lower the gain to the acquiring firm
as well as the higher the gain to the target company. However, Firm A may pay a large
premium to Firm B in order to allure the latter for acquisition. The ceiling will reach
where the price will be equal to the product of the EPS of the target company and the
price-earning ratio of the acquiring firm. In the above example, it is $2.67 x 8 = $21.36.
At this price, Firm B will receive 0.6675 share in Firm A in lieu of one share or in all
2,003 shares in Firm A, meaning that there will be in all 7,003 shares in the merged firm.
The EPS will be $28,000/7,003 shares = $4.0, which is equal to the pre-merger EPS in
Firm A. Assuming the price-earning ratio of 8, the value of the merged firm will be $32 x
7,003 shares or $224,096. Thus, at both the ceiling price and the floor price, the value of
the merged firm is almost the same. But at the ceiling price, the net gain to the acquiring
firm would just be zero because the gain from the merger will be reaped entirely by the
target company.

Considering Value
• Floor price = Market price of the share of the
target firm
• Ceiling price = EPS of the target firm x Price-
earning ratio of the acquiring firm
• Actual consideration value existing between
floor and ceiling price is influenced by bargain13
between the acquiring firm and the target firm
 In practice, the actual price is determined between these two limits, depending
upon the bargaining power of the acquiring firm and the target firm; and accordingly, the
net gain is shared partially by the acquiring firm and partially by the target firm. Suppose,
the consideration value is $20 per share of Firm B. In this case, Firm A will issue 0.625
share for each share in Firm B, which will be in all 1,875 shares. The value of owners’
wealth in Firm B would now be $32 x 1,875 shares or $60,000, as compared to $48,000
in the pre-merger period. The EPS of the merged firm would be $28,000 / 6,875 shares or
$4.07. Assuming a price-earning ratio of 8, the value of the merged firm will be $32.56 x
6875 shares or $223,850, which is higher than the sum of the value of the two firms in the
pre-merger period. The net gain to the acquiring firm as per equation 1 will be:

$ {223,850 – (160,000 + 48,000)} – (60,000 – 48,000)

= $3,850.

Thus, at a price agreed upon between the floor and the ceiling, both the acquiring
firm and the target firm will reap the benefits; and as a result, both will agree to the
merger. However, there are cases when the acquiring firm goes for acquisition even when
its net gain is zero. But this is done if some other significant benefits are going to accrue
to the acquiring firm.

The consideration value has so far been discussed in the absence of any changes
in the international environment. But in international M&A, such changes cannot be
overlooked. One of such changes in change in the exchange rate. The lower the existing
spot rate of the currency of the country to which target company belongs the lower the
price to be paid by the acquiring firm. If it is higher, the salvage value will be higher from
the viewpoint of the acquiring firm. If the future spot rate is expected to be higher, the
acquiring firm will receive a larger cash flow.

Secondly, it is the required rate of return that influences the value of the
acquisition. It is because the cost of capital varies from one country to another. This is
why the acquisition of a particular country’s firm may be more beneficial than in another
country.

Thirdly, the value of acquisition differs in case of different countries because the
ability to use financial leverage varies among countries. Since acquisition is financed
mostly through borrowings, acquisition of firms in a country where flexibility to borrow
is larger is more common. For example, in the United States, a high debt ratio if not
preferred, and the acquiring firm does not get much incentives on this count.
Last but not least, there are legal formalities regarding tax and accounting. If they
are favourable, they create competitive advantages for acquiring firms. This means that
when these rules are more favourable and liberal, the acquiring firm may bid a higher
price for acquisition.

CONTROL OF MNCs

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Since a lion’s share of FDI is accounted for by MNCs, their positive contribution to the
economy of the home country / host country is represented by the benefits derived by
them from the FDI. The benefits have already been discussed, which means that the
operation of MNCs is conducive for economic development, not only in the home
country/host country but in the global economy as well. However, the problem is that
MNCs are more interested in their own good, and frame and implement strategies
accordingly, with the result that their strategy comes into conflict with the interest of the
home country/host country. This is why it is often argued that the activities of MNCs
need to be controlled so that the interest of the home country / host country is better
served.

Conflicts with Home Country and Measures of Control

It is found that a larger number of multinational corporations shift their profits to a tax
haven and from there make further investment in different host countries. Again, they
hide their actual profit through the transfer pricing technique in order to evade taxes. It is
true that they do it in order to minimise their tax burden, but it is a loss of foreign
exchange and income to the state exchequer.

Sometimes R&D activities are spread over a number of subsidiaries. It is true that
the requirements of the host countries are taken into consideration but the home country
remains deprived of such facilities. This creates a negative impact on the employment of
scientific and technical personnel.

Again, MNCs enjoy economies of scale on account on their large production, with
the result that they charge low prices for products that are priced high in the domestic
market. Consequently, domestic manufactures are thrown out of the market in their home
country.

More often, under competitive pressures, MNCs locate a part of their operation in
resource rich/labour cheap countries under a vertical set-up. This helps cut costs and
enables the company to enjoy competitive advantage but causes loss of employment
generation and full use of the locally available resources in the home country.

These are the major reasons for conflict of interest between the home country
government and MNCs. In the sequel, the home country takes up a number of measures.
It is easier for the domestic government to take up restrictive measures insofar as the
home country executives as well as the home country shareholders may support the
government’s move.

First of all, the home government can prohibit any investment in, or any technical
collaboration with, a particular host country. For example, the US Government had not
allowed the transfer of the latest computer technology to East European countries during

15
1980s. Secondly, it can design fiscal and monetary disincentives to deter any outflow of
investment. Discriminatory tax can be levied. Exchange control mechanism can be
implemented. When the US balance of payments was sailing through rough weather
during late 1950s and early sixties, the Government had restricted the outflow of its
currency for overseas investment. Thirdly, the home government can tighten the approval
rules and regulations ultimately restricting FDI outflow. In India, during 1970s and
1980s, the Government had permitted foreign joint venture and also capital investment,
but the policy was restrictive. Fourthly, the government can introduce extra-territoriality
provisions and can interfere with the activities of its MNC’s foreign subsidiary, although
this option is rarely exercised. Last but not least, the home government can design an
anti-trust law that can trim its MNCs wings and restrict its operations in foreign markets.

Conflict with the Host Government and the Measures of Control

The conflict between MNCs and the home government is not as severe as it is with the
host government. There is often a feeling in the host country that the MNCs are taking
advantage of cheap resources available there and share the largest share of the resultant
profits. As a result, is that the government imposes high tax on the profits of the MNCs.
MNCs do not like this because they feel that they are utilizing unused resources, catering
to the demand of the local population, and giving employment to the local population.

Trade unions oppose multinationals because they do not find themselves in a

bargaining position, in view of maneuverability power of the firm during strikes. Again,
when senior positions are filled up by expatriates, it causes loss of employment which is
detrimental to the host country interests.

Local firms competing with MNCs also do not favour them. The host structure in
local industries is often high, in view of poor technology and lower size of production.
Local firms cannot market goods at a lower price as the MNCs are able to. The result is
that they are easily driven out of the market.

Sometimes consumers resent the existence of the MNCs. It is often found that
after MNCs are able to drive out local manufacturers from the market on account of
cheaper and more cost-effective products, they enjoy a monopolistic position. They raise
the price abnormally and exploit consumers.

MNCs charge an abnormally large price for the transfer of technology. They bring
their own inputs imported from the home country or sister unit in some other country at a
high price. They use transfer pricing on a large scale. All this adds to the balance of
payments of the host country. In India, for example, it was found that balance of
payments was severely affected by the operation of the MNCs during 1970s (Sharan,
1978).

Last but not least, MNCs adopt unethical practices, such as manufacturing health-
hazard products, bribing the officials, encouraging cross-border transfer of funds
circumventing the exchange control regulations in the host country, and so on, in many

16
cases. In a few cases, by bribing the politicians, they cause threat to the very political set-
up in the host country (Boatright, 1993).

Thus, with a view to limit the malpractices of MNCs, the host government tries to
implement some measures. First, the government insists on appointing government
representatives on the management board and on manning the senior positions with local
personnel who are expected to work in the interest of the host country. Recruitment for
low grade job with locals may lead to employment generation.

Secondly, the government insists on domestic participation in the equity share

capital. The profits are distributed among the local shareholders, minimizing the outflow
of scarce foreign exchange. Moreover, in such cases, there is every possibility of policy
of policy design, keeping intact the interest of the host country.

Thirdly, the government insists on purchase of inputs from local sources. The
practice provides stimulus to local industries supplying input, helps conserve scarce
foreign exchange, and also curbs the possibility of transfer pricing.

Fourthly, the host government puts in restrictive clauses in the import rules and
encourages strict surveillance in order to check unwarranted activities.

Last but not least, the host government expropriates the assets of MNCs lying in
its own country. Sometimes, it pays the compensation, but at other times it does not. Even
if compensation is paid, the amount is normally inadequate, and it usually takes a long
time to be realized. However, it is the last resort, especially where MNCs do not at all
abide by the host country rules and regulations.

Code for Control at the International Level

For the first time in 1971, the Group of 77 resolved to have surveillance on the activities
of MNCs so that the balance of payments of the low income countries is not strained on
account of greater outflow. Again, it was reiterated at the Non-aligned Conference of
1972 that foreign investment should be in conformity with the national development
objective in the host country. During 1970s, the UN Commission on Transnational
Corporations prepared a code of conduct for MNCs. The code requires an MNC to abide
by the socio-cultural objectives, share information with the host government and not to
engage in unethical activities.

Again, in 1977, the International Labour Organisation adopted a code that was
concerned with employment, training, working conditions and industrial relations. The
code stressed the need for consultation between the MNCs’ management and the
employees for a meaningful negotiation on a particular issue of discord.

The UNCTAD too issued two codes with respect to the operation of MNCs. The
first code issued in 1980 was concerned with the prevention of restrictive business
practices. The second code issued in 1983 related to the transfer of technology. Emphasis

17
was given on a reasonable payment for the technology received, especially by developing
countries and on the building up of technological capabilities in the technology receiving
developing countries.

There are thus a number of mechanisms for controlling MNCs’ operation both at
the national and the international levels. The mechanisms at the national level are better
implemented. But those at the international level are only suggestive and not biding on
MNCs, with the result that they are not very effective. The need of the day is to make the
international codes legally binding.

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