1

CONTENTS OF 3RD UNIT

3.

MULTINATIONAL CORPORATE DECISIONS IN GLOBAL MARKETS............................4

3.1. FOREIGN INVESTMENT DECISIONS:.........................................................4
3.2. FOREIGN DIRECT INVESTMENT (FDI).......................................................5
3.2.1.

MEANING AND DEFINITION OF FDI...........................................................5

3.2.2.

TYPES OF FOREIGN DIRECT INVESTMENT................................................5

3.2.3.

FACTORS/DETERMINANTS OF FOREIGN DIRECT INVESTMENT..................6

3.2.4.

MOTIVES OF FOREIGN DIRECT INVESTMENT:...........................................8

3.2.5.

RESOURCES AND METHODS FOR MAKING FDI:......................................10

3.2.6.

STRATEGY FOR FDI:................................................................................ 11

3.2.7.

MEASURES TO ATTRACT FDI INFLOWS INTO THE COUNTRY:..................13

3.2.8.

FOREIGN DIRECT INVESTMENT THEORIES:............................................13

3.2.8.1. Theory of Comparative Advantage/Porters Diamond Model:

National Competitive Advantage Theory:...............................................14
3.2.8.2. OLI/Dunnings Eclectic Paradigm/Eclectic Theory:.................16
3.2.8.3. Monopolistic Advantage Theory:...............................................17
3.2.8.4. Internalization Theory:...............................................................18
3.2.9.

MODES OF FOREIGN INVESTMENT:........................................................19

3.2.9.1. Licensing:...................................................................................... 19
3.2.9.2. Management contracts...............................................................20
3.2.9.3. Joint Ventures:..............................................................................21
3.2.9.4. Greenfield Investment:...............................................................22
3.2.9.5. Acquisitions:................................................................................. 23
3.2.9.6. Strategic Alliances:.....................................................................23
3.2.9.7. Exporting:..................................................................................... 24
3.2.9.8. Franchising................................................................................... 26
3.2.9.9. Turnkey Contracts:......................................................................27
3.2.10. COSTS AND BENEFITS OF FDI:...............................................................27
3.2.10.1.Benefits to Host Country:...........................................................27
3.2.10.2.Benefits to Home Country:.........................................................28
3.2.10.3.Cost to Host Country:..................................................................29
3.2.10.4.Cost to Home Country:................................................................29
3.3. FOREIGN PORTFOLIO INVESTMENT........................................................30

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3.3.1.

MEANING OF FOREIGN PORTFOLIO INVESTMENT:..................................30

3.3.2.

INTERNATIONALIZING THE DOMESTIC PORTFOLIO.................................30

3.3.3.

INTERNATIONAL PORTFOLIO DIVERSIFICATION......................................31

3.3.3.1. Rationale for International Portfolio Diversification..............33

3.3.3.2. Barriers to International Portfolio Investment.......................34
3.3.3.3. Home Country Bias......................................................................35
3.3.4.

FACTORS AFFECTING FOREIGN PORTFOLIO INVESTMENT......................36

3.3.5.

MODES OF FOREIGN PORTFOLIO INVESTMENT......................................37

3.3.6.

ADVANTAGES OF FOREIGN PORTFOLIO INVESTMENT.............................37

3.3.7.

DISADVANTAGES OF FOREIGN PORTFOLIO INVESTMENT.......................38

3.4. INTERNATIONAL CAPITAL BUDGETING...................................................39

3.4.1.

CONCEPT OF INTERNATIONAL CAPITAL BUDGETING:.............................39

3.4.2.

FACTORS AFFECTING INTERNATIONAL CAPITAL BUDGETING.................40

3.4.3.

EVALUATION OF PROJECT.......................................................................42

3.4.4.

EVALUATION OF OVERSEAS INVESTMENT PROPOSAL............................42

3.4.4.1. Evaluation of Overseas Investment Proposal Using

Discounted Cash Flow Analysis (DCF)......................................................43
3.4.4.2. Evaluation of Overseas Investment Proposal Using Adjusted
Present Value Model (APV)........................................................................45
3.4.5.

PROBLEMS ASSOCIATED WITH INTERNATIONAL CAPITAL.......................46

3.5. MULTINATIONAL CORPORATION (MNC).................................................48

3.5.1.

MEANING AND DEFINITION OF MNC.......................................................48

3.5.2.

FINANCIAL GOALS OF MNC....................................................................48

3.5.3.

REASONS FOR THE GROWTH OF MULTINATIONAL CORPORATIONS........49

3.5.4.

MULTINATIONAL CORPORATE STRUCTURE.............................................50

3.5.5.

FINANCIAL PERFORMANCE MEASUREMENT...........................................50

3.5.5.1. Mechanics of Performance Measurement................................51

3.5.5.2. Effective Performance Measurement System.........................51
3.5.5.3. Factors Considered in Performance Measurement................52
3.6. MULTINATIONAL CAPITAL STRUCTURE DECISION................................54
3.6.1.

INTRODUCTION...................................................................................... 54

3.6.2.

SITUATIONS DETERMINING MULTINATIONAL FIRMS CAPITAL STRUCTURE

54

3.6.3.

FACTORS AFFECTING MNCS CAPITAL STRUCTURE.................................55

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3.6.4.

OPTIMAL FINANCIAL/CAPITAL STRUCTURE OF MNC...............................56

3.7. INTERNATIONAL COST OF CAPITAL........................................................57

3.7.1.

MEANING OF COST OF CAPITAL.............................................................57

3.7.2.

COST OF EQUITY.................................................................................... 57

3.7.3.

COST OF DEBT....................................................................................... 58

3.7.4.

WEIGH FED AVERAGE COST OF CAPITAL (WACC)...................................59

3.7.5.

COST OF CAPITAL ACROSS COUNTRIES.................................................59

3.7.5.1. Country Differences in Cost of Debt.........................................59

3.7.5.2. Country Differences in Cost of Equity......................................60
3.7.5.3. Cost of Capital for MNCs Vs Domestic Firms...........................60
3.8. INTERNATIONAL CASH MANAGEMENT...................................................61
3.8.1.

MEANING OF CASH MANAGEMENT.........................................................61

3.8.2.

OBJECTIVES OF INTERNATIONAL CASH MANAGEMENT...........................62

3.8.3.

CASH FLOWS OF A SUBSIDIARY.............................................................62

3.8.4.

CENTRALIZED CASH FLOW MANAGEMENT.............................................63

3.8.4.1. Centralized versus Decentralized Cash Management...........64

3.8.4.2. Location of the Centralized Pool...............................................64
3.8.4.3. Advantages of Centralized Cash Management.......................65
3.8.4.4. Disadvantages of Centralized Cash Management..................65
3.9. PROJECT FINANCE..................................................................................... 66
3.9.1.

MEANING OF PROJECT FINANCE.............................................................66

3.9.2.

SOURCES OF PROJECT FINANCE.............................................................66

3.9.3.

INSTRUMENTS OF PROJECT FINANCING.................................................67

3.9.4.

ADVANTAGES OF PROJECT FINANCING...................................................70

3.9.5.

DISADVANTAGES OF PROJECT FINANCING.............................................71

3. MULTINATIONAL CORPORATE DECISIONS IN

GLOBAL MARKETS
3.1. FOREIGN INVESTMENT DECISIONS:
Foreign investment is a type of investment that involves purchasing securities that
originate in other countries. This type of investment is popular because it can
provide diversification and opportunities for superior growth. There are many
different ways to invest internationally including through mutual funds, Exchange
Traded Funds (ETFs) and American depository receipts. International investing is a
procedure that many investors choose to get involved in by investing money
outside of their domestic market. For example, instead of holding a portfolio of only
domestic stocks and bonds, an investor could purchase some stocks from a foreign
country or buy shares of a mutual fund that specializes in international investment.
Foreign investment decision is a tough and often complex investment decision that
sharply differs from the traditional domestic decision on investing. Foreign
investment decisions consist of a complex process that differs in many respects
from domestic investment decisions. The complexity arises from different sets of
strategic, motivational, and economic considerations far wider than a better known
domestic market environment. Foreign investment is normally overshadowed by
political and foreign exchange risk considerations, surpassed by longer process, cost
overruns, and less familiarity with the participating market. What motivates a
corporation to enter the foreign market is the intuition of higher earnings potential,
the saturation of the domestic market, or the forces of market competition and
customers demand for a greater variety of services on a worldwide basis. Banks,
like any other industrial corporation, are faced with a similar challenge. In fact, in
some respects, they see a greater challenge than manufacturing or other service
industries because the nature of the banking business requires far more liquidity
than other business structures.
Foreign investment decision is a decision to invest abroad takes a concrete shape
when a future project is evaluated in order to ascertain whether the implementation
of the project is going to add to the value of the investing company. The evaluation
of the long-term investment project is known as capital budgeting. The technique of
capital budgeting is almost similar between a domestic company and an
international company. The only difference is that some additional complexities appear
in the case of international capital budgeting. These complexities influence the
computation of the cashflow and the required rate of return.
Foreign investment or capital flows fall into following categories:
1) Foreign Direct Investment (FDI): Pertains to international investment in
which the investor obtains a lasting interest in an enterprise in another
country. Most concretely, it may take the form of buying or constructing a

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factory in a foreign country or adding improvements to such a facility, in the
form of property, plants, or equipment.
2) International Portfolio Investment (FPI): On the other hand is a category
of investment instruments that is 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 which does not necessarily represent a long-term interest.

Profits,
royaltiestechnology,
and fees management
Investment,
know-how
Recipient
Investor
(Foreign)
(Domestic)

3.2. FOREIGN DIRECT INVESTMENT (FDI)

3.2.1. MEANING AND DEFINITION OF FDI
Capital flows in the form of foreign direct investment (FDI) have been widely
believed to be an important source of growth in recent year, FDI is the process
whereby residents of one country (the source country) acquire ownership of assets
for the purpose of controlling the production, distribution and other activities of a
firm in another country (the host country).
'
The International Monetary Funds Balance of Payments Manual defines FDI
as, An investment that is j made to acquire a lasting interest in an enterprise

6
operating in an economy other than that of the investor, the investors purpose
being to have an effective voice in the management of the enterprise.
The United Nations World Investment Report (UNCTAD, 1999) defines FDI
as, An investment involving a long-term relationship and reflecting a lasting
interest and control of a resident entity in one economy (foreign direct investor or
parent* enterprise) in an enterprise resident in an economy other than that of the
foreign direct investor (FDl enterprise, affiliate enterprise or foreign affiliate).
The term long-term is used in the last definition in order to distinguish FDI from
portfolio investment; FDI does not have the portfolio investment characteristic of
being short-term in nature, involving a high turnover of securities,
foreign direct investment (FDI) is permitted under the following forms of
investments:
1) Through joint ventures, financial and technical collaborations,
2) Through capital markets via Euro issues,
3) Through private placements or preferential allotments.

3.2.2.

TYPES OF FOREIGN DIRECT INVESTMENT

Following are the types of foreign direct investment:

Types of Foreign Direct Investment

Horizontal Foreign Direct Investment

Vertical Foreign Direct Investment
Greenfield Investment
Mergers and Acquisition

1) Horizontal Foreign Direct Investment: Horizontal FDI refers to the

-foreign manufacturing of products and services roughly similar to those the
firm produces in its home market. This type %f FDI is called horizontal
because the multinational duplicates the same activities in different
countries. Horizontal FDI arises because it is too costly to serve the foreign
market by exports due Jo transportation costs or trade barriers.

7
2) Vertical Foreign Direct Investment: Vertical FDI refers to those
multinationals that fragment production process geographically. It is called
^vertical" because MNE separates the production chain vertically by
outsourcing some production stages abroad. The basic idea behind the
analysis of this type of FDI is that a production process consists of multiple
stages with different input requirements. If input prices varies across
countries, it becomes profitable for the firm to split the production chain.
3) Greenfield Investment: Greenfield investment refers to a scenario where a
national firm becomes multinational. This means that if a national firm in
country A becomes multinational, then there is one less national firm in
country A and one more firm producing in country B. Three hypotheses can
be made for why a firm may become multinational. The number of
multinationals producing in a country or market, relative to the number of
national firms will be greater as trade barriers increase, plant-level fixed costs
decrease, and the host country market grows. As long as barriers to trade are
high, that is trade openness is low and trade costs are low, then firms have
an incentive to undertake Greenfield investment.
4) Mergers and Acquisition: The other form of horizontal FDI is a merger and
acquisition. This type of investment occurs when an existing firm takes over
or merges with a foreign firm, this form of FDI is modeled by a national firm in
country A changing to become a multinational firm headquartered in country
A, together with a takeover and disappearance of a firm in country B.

3.2.3. FACTORS/DETERMINANTS OF FOREIGN

DIRECT INVESTMENT
The volume of FDI in a country depends on the following factors:
1) Rate of Return on the Underlying Project: The differential rates of
hypothesis represent one of the first attempts to explain FDI flows. This
hypothesis postulates that capital flows from countries with low rates of
return to countries with high rates of return move in a process that eventually
leads to the equality of ex ante real rates of return.
2) Return and risk: When the assumption of risk neutrality is relaxed, risk
becomes another variable upon which the FDI decision is made. If this
proposition is accepted, then the differential rates of return hypothesis
become inadequate, in which case we resort to the diversification (or
portfolio) hypothesis to explain FDI.
3) Natural Resources: Availability of natural resources in the host country is a
major determinant of FDI. Most foreign investors seek an adequate, reliable
and economical source of minerals and other materials, FDI tends to flow in
countries which are rich in resources but lack capital, technical skills and
infrastructure required for the exploitation of natural resources. Though their
relative importance has declined, the availability of natural resources still
continues to be an important determinant of FDI

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4) Availability of Cheap Labour: The availability of low cost unskilled labour
has been a major course of FDI in countries like China and India. Low cost lab
our together with availability of cheap raw materials enables foreign investors
to minimize costs of production and thereby increase profits.
5) Market Size: The volume of FDI in a host country depends on its market
size. This hypothesis is particularly valid for the case of import-substituting
FDI. As soon as the size of the market of a particular country has grown to a
level warranting the exploitation of economies of scale, this country becomes
a potential target for FDI inflows.
6) Socio-Economic Conditions: Size of the population, infrastructural facilities
and income level of a country influence direct foreign investment...
7) Political Situation: Political stability, legal framework, judicial system,
relations with other countries and, other political factors influence
movements of capital from one country to another.
8) Need for Internalization: According to the internalization hypothesis, FDI
arises from efforts by firms to replace market transactions with internal
transactions. For example, if there are problems associated with buying oil
products on the market, a firm may decide to buy a foreign refinery. These
problems arise from imperfections and failure of markets for intermediate
goods, including human. Capital, knowledge, marketing and management
expertise.
9) International Immobility of Factors of Production: According to the
location hypothesis, FDI exists because of the international immobility of
some factors of production such as labor and natural resources. This
immobility leads to location-related differences in the costs of factors of
production.
10)
Strategic and Long-Term Factors: Some strategic and long-term
factors have been put forward to explain FDI. These factors include the
following:
i).
The desire on the part of the investor to defend existing foreign
markets and foreign investments against competitors.
ii).
The desire to gain and maintain a foothold in a protected market or to
gain and maintain a source of supply that may prove useful in the longrun.
iii).
The need to develop and sustain a parent-subsidiary relationship.
iv).
The desire to induce the host country into a long commitment to a
particular type of technology.
v).
The advantage of complementing another type of investment.
vi).
The economies of new product development.
vii).
Competition for market shares among oligopolistic and the concern for
strengthening bargaining positions.

3.2.4. MOTIVES OF FOREIGN DIRECT

INVESTMENT:
MNCs commonly consider foreign direct investment because it can improve their
profitability and enhance shareholder wealth. In most cases, MNCs engage in FDI
because they are interested in boosting revenues, reducing costs, or both:

Motives of Foreign Direct Investment

Revenue-Related Motives
Cost-Related Motives

Attract New Sources of Demand

Enter Profitable Markets
Exploits Monopolistic Advantages
React to Trade Restrictions
Diversify Internationally

Fully Benefit from Economies of Scale

Use Foreign Factors of Production
Use Foreign Raw Materials
Use Foreign Technology
React to Exchange Rate Movements

1) Revenue-Related Motives: The following are typical motives of MNCs that

are attempting to boost revenues:
i).
Attract New Sources of Demand: A corporation often reaches a
stage when growth is limited in its home country, possibly because of
intense competition. Even if it faces little competition, its market share
in its home country may already be near its potential peak. Thus, the
firm may consider foreign markets where there is potential demand.
Many developing countries, such as Argentina, Chile, Mexico, Hungary,
and China, have been perceived as attractive sources of new demand.
Many MNCs have penetrated these countries since barriers have been
removed. Because the consumers in some countries have historically
been restricted from purchasing goods produced by firms outside their
countries, the markets for some goods are not well established and
offer much potential for penetration by MNCs.

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ii).

Enter Profitable Markets: If other corporations in the industry have

proved that superior earnings can be realized in other markets, an MNC
may also decide to sell in those markets. It may plan to undercut the
prevailing, excessively high prices. A common problem with this
strategy is that previously established sellers in a new market may
prevent a new competitor from taking away their business by lowering
their prices just when the new competitor attempts to break into this
market.
iii).
Exploit
Monopolistic
Advantages:
Firms
may
become
internationalized if they possess resources or skills not available to
competing firms. If a firm possesses advanced technology and has
exploited this advantage successfully in local markets, the firm may
attempt to exploit it internationally as well. In fact, the firm may have a
more distinct advantage in markets that have less advanced
technology.
iv).
React-to Trade Restrictions: In some cases, MNCs use DFI as a
defensive rather than an aggressive strategy. Specifically, MNCs may
pursue DFI to circumvent trade barriers.
v).
Diversify Internationally: Since economies of countries do not move
perfectly in tandem over time, net cashflow from sales of products
across countries should be more stable than comparable sales of the
products in a single country. By diversifying (and possibly even
production) internationally, a firm can make its net cashflows less
volatile. Thus, the possibility of a liquidity deficiency is less likely. In
addition, the firm may enjoy a lower cost of capital as shareholders
and creditors perceive the MNCs risk to be lower as a result of more
stable cashflows.
2) Cost-Related Motives: MNCs also engage in DFI in an effort to reduce
costs. The following are typical motives of MNCs that are trying to cut costs:
i).
Fully Benefit from Economies of Scale: A corporation that attempts
to sell its primary product in new markets may increase its earnings
and shareholder wealth due to economies of scale (lower average cost
per unit resulting from increased production). Firms that utilize much
machinery are most likely to benefit from economies of scale.
ii).
Use Foreign Factors of Production: Labor and land costs can vary
dramatically among countries. MNCs often attempt to set-up
production in locations where land and labor are cheap. Due to market
imperfections such as imperfect information, relocation transaction
costs, and barriers to industry entry, specific labor costs do not
necessarily become equal among markets. Thus, it is worthwhile for
MNCs to survey markets to determine whether they can benefit from
cheaper costs by producing in those markets.
iii).
Use Foreign Raw Materials: Due to transportation costs, a
corporation may attempt to avoid importing raw materials from a given
country, especially when it plans to sell the finished product back to

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iv).

v).

consumers in that country. Under such circumstances, a more feasible

solution may be to develop the product in the country where the raw
materials are located.
Use Foreign Technology: Corporations are increasingly establishing
overseas plants or acquiring existing overseas plants to learn the
technology of foreign countries. This technology is then used to
improve their own production processes and increase production
efficiency at all subsidiary plants around the world.
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.

A related reason for such DFI is to offset the changing demand for a companys
exports due to exchange rate fluctuations. For example, when Japanese automobile
manufacturers build plants in the United States, they can reduce exposure to
exchange rate fluctuations by incurring dollar costs, for their production that offset
dollar revenues. Although MNCs do not engage in large projects simply as an
indirect means of speculating on currencies, the feasibility of proposed projects may
be dependent on existing and expected exchange rate movements.

3.2.5. RESOURCES AND METHODS FOR MAKING

FDI:
Following are the resources and methods used for making FDI:
1) Assets Employed: Foreign direct investment is usually an international
capital movement that crosses borders when the anticipated return
(accounting for the risk factor and the cost of transfer) is higher overseas
than at home. Although most FDI requires some type of international capital
movement, an investor may transfer many other types of assets. For
example, Westin Hotels has transferred very little capital to foreign countries
Instead, it has transferred managers, cost control systems and reservations
capabilities in exchange for ownership in foreign hotels.
2) Buy-Versus-Build Decision
i).
Reasons for Buying: Whether a Company makes a direct investment
by acquisition or start-up depends, of course, on which companies
areavailableT&Kurchase. The large privatization programs occurring
in many parts of the world have put hundreds of companies on the
market and MNEs have exploited this new opportunity to invest
abroad. For example, foreign companies, such as Vivendi from France,
bought many British utility companies when they were privatized.
There are many reasons for seeking acquisitions. One is the difficulty of
transferring some resource to a foreign operation or acquiring that
resource locally for a new facility, especially if the company feels it
needs to adapt substantially to the local environment or operate
through a multi-domestic strategy. Personnel are a resource that

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ii).

3.2.6.

foreign companies may find difficult to hire, especially if local

unemployment is low. Instead of paying higher compensation than
competitors do to entice employees away from their old jobs; a
company can buy an existing company, which gives the buyer, not
only labour and management but also an existing organizational
structure. This may be particularly important if the company is making
an FDI to augment its capabilities, such as to acquire knowledge.
Through acquisitions, a company may also gain the goodwill and brand
identification important to the marketing of mass consumer products,
especially if the cost and risk of breaking in a new brand are high.
Further, a company that depends substantially oil local financing rather
than on the transfer of capital may find it easier to gain access to local
capital through an acquisition. Local capital suppliers may be more
familiar with an ongoing operation than with the foreign enterprise. In
addition, a foreign company may acquire an existing company through
an exchange of stock.
Finally, by buying a company, an investor avoids inefficiencies during
the start-up period and gets an immediate cash flow rather than the
problem of tying up funds during construction.
Reasons for Building: Although acquisitions offer advantages, a
potential investor will not necessarily be able to realize them.
Companies frequently make foreign investments in sectors where there
are few, if any, companies operating, so finding a company to buy may
be difficult. In addition, local governments may prevent acquisitions
because they want more competitors in the market and fear market
dominance by foreign enterprises. Even if acquisitions are available,
they often do not succeed. The acquired companies might have
substantial problems. Personnel and labour relations may be both poor
and difficult to change, ill will may have accrued to existing brands or
facilities may be inefficient and poorly located.
Further, the managers in the acquiring and acquired companies may
not work well together, particularly if the two companies are
accustomed to different management styles and practices or if the
acquiring company tries to institute many changes.

STRATEGY FOR FDI:

When a firm decides to operate in a foreign land, it needs to follow a specific

strategy in order to make its operation a viable one. The strategy must be designed
so as to enable it to have an edge over competing firms. To this end, the firm may
concentrate either on product innovation, product differentiation, on the cartels and
collusion, or on some other strategies.
In fact, the strategy depends to a great extent on how mature the product is or how
designed its cost structure is.

13
Following are the strategies for FDI:
1) Firm-Specific Strategy: When a firm has already spent a huge sum of
money on research and development, it normally stresses on serving the
consumers abroad with an innovated product and this gives it a definite edge
over competing firms. Such products are generally price-inelastic which helps
die firm earn greater profits but the life span of this strategy is limited. After
some time, the technology does not remain the exclusive monopoly of the
firm and the competing firms too begin to produce similar goods.
When the product-innovation strategy fails to work, a firm may adopt a
product-differentiation strategy. This is done through putting a trademark on
the product, or in other words, through branding the product. Branding
substitutes to a great extent the product-innovation strategy, in so far as the
branded product enjoys an exclusive status, quite different from similar
products in the market.
Sometimes the firm adopts different brands for different markets to make
them more suitable for a local market on different grounds or to reap market
segmentation benefits. For example, Unilevers low-lather fabric washing
product is marketed under five different brands in Western Europe.
2) Cost-Economizing Strategy: When a firms product becomes standardized
and it faces competition from similar products of other firms, the firm tries to
locate its subsidiary in a country where either raw material or labor is cheap.
Cheapness of these factors of production provides the firm an opportunity to
reduce the cost of production and to maintain an edge over other firms. For
example, if an MNC invests abroad in the raw material sector, it would be
able to get that particular raw material at a lower cost and to export it either
to the parent unit or to any other subsidiary. The unit getting cheap raw
material will be at a competitive advantage. Again,- it is the availability of
cheap labour force in developing countries that has led the US and other
multinationals to go for off-shore operations there. Such operations are
normally vertical operations where the capital-intensive part of production is
located in industrialized countries and labour-intensive part of production is
located in the developing world.
3) Strategy of Entering in New Areas: Since the two strategies mentioned
above have limited life span, the firm tries to enter a new area where
competition is yet to begin. Shapiro (1995) has cited an example of Crown
Cork and Seal which is headquartered in Philadelphia and has gone for
operation in Thailand, Malaysia, Zambia and Peru making bottle tops and
cans. The very reason for its foreign operation was that the field was
uncultivated and there was no competition.
4) Cross-Investment Strategy: In some cases, a firm begins its foreign
operation not primarily for capturing the foreign market or for reducing the
cost of production, but to avoid price cuts by competing firms. If a country a
firm sets up a manufacturing or trading unit in country B, there is probability
for a country B firm to operate in country A. In such cases, if the former goes

14
for a cut in the price, the latter too will adopt the same strategy as a
retaliatory measure.
5) Joint Venture with Rival Firm : Sometimes, when a rival firm in the host
country is so powerful that it is not easy for the MNC to compete, the latter
prefers to join hands with the host country firm for a joint- venture agreement
and the MNC thus is able to penetrate the host-country market.
Whatever strategy is adopted by the MNCs abroad, there are certain
necessary pre-conditions which are as follows:
i).
They should have an idea of the profitable investment opportunities
and the ways to tap those opportunities.
ii).
Each and every strategy must be carefully evaluated since a particular
project may not be competitive on all fronts. If one strategy is not
useful, the firm should go in for another strategy.
iii).
The firm must evaluate the life span of each strategy. It must possess
the flexibility of switching over from one strategy to another, especially
when the life span of a particular strategy comes to an end.
6) Mode of Investment: The mode of investment abroad is one of the most
crucial strategies. If the mode is not suitable, the investment cannot be a
viable venture. However, it may be noted that selection of a particular mode
does not depend solely on the wishes of the investing company, but also
upon the economic and political environment in the host country. If the host
government does not allow a particular mode, the investing company cannot
adopt it even if it is the most suitable for it. The most common modes of
investment are:
i).
Operation through Branches.
ii).
Foreign Collaborations:
a) Financial collaboration:
Wholly-owned subsidiary.
Subsidiary.
Affiliate.
b) Technical collaboration
Franchise.
Turn-key projects.
Management contract.
iii).
Mergers and Acquisitions
a) Horizontal.
b) Vertical.
c) Conglomerate.

3.2.7. MEASURES TO ATTRACT FDI INFLOWS INTO

THE COUNTRY:
The measures to attract FDI inflows into the country are as follows:
1) Reducing Obstacles: The main measure to attract FDI is to reduce
obstacles to FDI by removing restrictions on admission and establishment, as

15
well as on the operations of foreign affiliates. The key issue here is how
investment is to be defined for liberalizing entry or offering protection (direct
and portfolio capital flows may be treated differently) and what kind of
control should be exercised over FDI admission and establishment.
2) Improving Standards: By improving standards of treatment of foreign
investors by granting them non- discriminatory treatment about domestic or
other foreign investors, one can attract FDI inflows into the country. The key
issue here is what degree of national treatment should be granted to foreign
affiliates once they are established in a host country.
3) Protection of Foreign Investors: Protecting foreign investors through
provisions on compensation in the event of nationalization or expropriation,
on dispute settlement and on guarantees on the transfer of funds is one of
the ways to attract FDI inflow into the country. A key issue here is how far the
right to expropriate or nationalize extends (especially to what extent certain
regulatory actions of governments constitute takings of foreign property).
Another is the acceptability of the kind of dispute settlement mechanisms
available to foreign investors and countries. Third is what restrictions, if any,
are acceptable on the ability of governments to introduce capital controls to
protect the national economy.
4) Other Measures: Other measures of promoting FDI inflows are that enhance
a countrys image, provide I information on investment opportunities, offer
location incentives, facilitate FDI by institutional and administrative
improvements and render post-investment services. Host countries do most
of this, but home countries may also play a role. The key issues here relate to
the use of financial, fiscal or other incentives (including regulatory
concessions) and the actions that home countries can take to encourage FDI
flows to developing countries.

3.2.8.

FOREIGN DIRECT INVESTMENT THEORIES:

The theories of foreign direct investment comprises both ownership and control of
international investments I involving real or physical assets such as plants and other
facilities, rather than theories regarding other types of I international investment
such as portfolios of stocks, bonds, or other forms of debt.

16

Foreign Direct Investment Theories

Theory of Comparative Advantage/Porters Diamond Model:

National Competitive Advantage Theory OLI/ Dunnings Eclectic Paradigm/Eclectic Theory

Monopolistic Advantage Theory

Internalization Theory

3.2.8.1.
Theory of Comparative
Advantage/Porters Diamond Model: National
Competitive Advantage Theory:
The focus of early trade theory was on the country or nation and its inherent,
natural, or endowment characteristics that might give rise to increasing
competitiveness. As trade theory evolved, it shifted its focus to the industry and
product level, leaving the national-level competitiveness question somewhat
behind.

17

Porters Diamond Model for Competitiveness

In 1990, Michael Porter of the Harvard Business School published the results of an
intensive research effort that attempted to determine why some nations succeed
and others fail in international competition.
These four points, as illustrated in figure 3.2, constitute what nations and firms must
strive to create and sustain through a highly localized process to ensure their`
success.

18
Components of Porter Diamond
According to porter, a nations competitiveness depends on the capacity of its
industry to innovate and upgrade.
Porter argued innovation is what drives and sustains competitiveness. A firm must
avail itself of all dimensions of competition, which he categorized into four major
components of the diamond of national advantage.
Figure 3.2 provides an illustration of the complete system of these components and
external variables. Each of the four determinants affects the others and all in turn is
affected by the role of chance and government.
1) Factor Conditions: The appropriateness of the nations factors of production
to compete successfully in a specific industry. Porter notes that although
these factor conditions are very important in the determination of trade, they
are not the only source of competitiveness as suggested by the classical, or
factor proportions, theories of trade. Most importantly for Porter, it is the
ability of a nation to continually create, upgrade, and deploy its factors (such
as skilled labor) that are important, not the initial endowment.
2) Demand Conditions: The degree of health and competition the firm must
face in its original home market. Firms that can survive and flourish in highly
competitive and demanding local markets are much more likely to gain the
competitive edge. Porter notes that it is the character of the market, not its
size that is paramount in promoting the continual competitiveness of the
firm. And Porter translates character as demanding customers.
3) Related and Supporting Industries: The competitiveness of all related
industries and suppliers to the firm. A firm that is operating within a mass of
related firms and industries gains and maintains advantages through close
working relationships, proximity to suppliers, and timeliness of product and
information flows. The constant and close interaction is successful if it occurs
not only in terms of physical proximity but also through the willingness of
firms to work at it.
4) Firm Strategy, Structure, and Rivalry: The conditions in the home-nation
that either hinder or aid in the firms creation and sustaining of international
competitiveness. Porter notes that no one managerial, ownership, or
operational strategy is universally appropriate. It depends on the fit and
flexibility of what works for that industry in that country at that time.
Porters emphasis on innovation as the source of competitiveness reflects an
increased focus on the industry and product that we have seen in the past three
decades. The acknowledgment that the nation is more, not less, important is to
many eyes a welcome return to a positive role for government and even nationallevel private industry in encouraging international competitiveness. Including factor
conditions as a cost component, demand conditions as a motivator of firm actions,
and competitiveness all combine to include the elements of classical, factor
proportions, product cycle, and imperfect competition theories in a pragmatic

19
approach to the challenges that the global markets of the twenty-first century
present to the firms of today.
Limitations of the Porters Diamond Theory
The existence of the four favorable conditions does not guarantee that an industry
will develop in a given locale. Entrepreneurs may face favorable conditions for many
different lines of business. In fact, comparative advantage theory holds that
resource limitations may cause, companies in a country to avoid competing in some
industries even though an absolute advantage may exist. For example, conditions in
Switzerland would seem to have favored success if companies in that country had
become players in the personal computer industry. However, Swiss companies
preferred to protect their global positions in such product lines as watches and
scientific instruments rather than to downsize those industries by moving their
highly skilled people into a new industry.
A second limitation concerns the increased ability of .companies to attain market
information, production factors, and supplies from abroad. Actually this complex
issue could be broken into four separate considerations, as given below:
1) Observations of foreign or foreign plus domestic, rather than just domestic,
demand conditions have spurred much of the recent growth in Asian exports.
In fact, such Japanese companies as Uniden and Fujitech target their sales
almost entirely to foreign markets.
2) Companies and countries are not dependent entirely on domestic factor
conditions. For example, capital and managers are now internationally
mobile.
3) If related and supporting industries are not available locally, materials and
components are now more easily brought in from abroad because of
advancements in transportation and the relaxation of import restrictions. In
fact, many MNEs now assemble products with parts supplied from a variety of
countries.
4) Companies react not only to domestic rivals but also to foreign-based rivals
they compete with at home and abroad. Thus, the absence of any of the four
conditions from the diamond domestically may not inhibit companies and
industries from becoming globally competitive.

3.2.8.2.
OLI/Dunnings Eclectic
Paradigm/Eclectic Theory:
Professor John Dunning proposed the eclectic paradigm as a framework for
determining the extent and pattern ' 0f the value-chain operations that companies
own abroad. Dunning draws from various theoretical perspectives including the
comparative advantage and the factor proportions, monopolistic advantage, and
internalization advantage theories. The eclectic theory is the most widely cited and
accepted theory of FDI currently. The eclectic theory of international production

20
attempts to provide an overall framework for explaining why firms choose to
engage in FDI rather than serve foreign markets through alternatives such as
exporting, licensing, management contracts, joint ventures, or strategic alliances.
The eclectic paradigm specifies three conditions that determine whether or not a
company will internationalize via FDI:
1) O-Ownership-Specific Advantages: To successfully enter and conduct
business in a foreign market, the MNE must possess ownership-specific
advantages (unique to the firm) relative to other firms already doing business
in the market. These consist of the knowledge, skills, capabilities, processes,
relationships, or physical assets held by the firm that allows it to compete
effectively in the global marketplace. They amount to the firms competitive
advantages. To ensure international success, the advantages must be
substantial enough to offset the costs that the firm incurs in establishing and
operating foreign operations. They also must be specific to the MNE that
possesses them and not readily transferable to other firms. For example,
proprietary technology, managerial skills, trademarks or brand names,
economies of scale, and access to substantial financial resources. The more
valuable the firms ownership-specific advantages, the more likely it is to
internationalize via FDI.
2) L-Location-Specific Advantages: These refer to the comparative
advantages that exist in individual foreign countries. Each country possesses
a unique set of advantages from which companies can derive specific
benefits. For example, natural resources, skilled labor, low-cost labor, and
inexpensive capital. Sophisticated managers recognize and seek to benefit
from the host country advantages. A location-specific advantage must be
present for FDI to succeed. It must be profitable to the firm to locate abroad,
i.e., to utilize its ownership-specific advantages in conjunction with atleast
some location-specific advantages in the target country. Otherwise, the firm
would use exporting to enter foreign markets.
3) I-Internalization Advantages: These are the advantages that the firm
derives from internalizing foreign- based manufacturing, distribution, or other
stages in its value chain. When profitable, the firm will transfer its ownershipspecific advantages across national borders within its own organization,
rather than dissipating them to independent, foreign entities. The FDI
decision depends on which is the best option - internalization versus utilizing
external partners whether they are licensees, distributors, or suppliers.
Internalization advantages include the ability to control how the firms
products are produced or marketed, the ability to control dissemination of the
firms proprietary knowledge, and the ability to reduce buyer uncertainty
about the value or products the firm offers.
Because of the names of these three types of advantages that a firm must have, the
eclectic theory of international production is sometimes referred to as the OLI
model. This theory provides an explanation for an international firms choice of its

21
overseas production facilities. The firm must have both location and ownership
advantages to invest in a foreign plant. It will invest where it is most profitable to
internalize its monopolistic advantage. These investments can be proactive, being
strategically anticipated and controlled in advance by the firms management team,
or reactive, in response to the discovery of market imperfections:

3.2.8.3.

Monopolistic Advantage Theory:

The modem monopolistic advantage theory stems from Stephen Hymers

dissertation in the 1960s, in which he demonstrated that foreign direct investment
occurs largely in oligopolistic industries rather than in industries operating under
near-perfect competition. This means that the firms in these industries must
possess advantages not available to local firms in order to overcome liabilities
associated with being a foreigner - such as lack of knowledge about local market
conditions, increased cost of operating at a distance, 6r differences in culture,
language, laws and regulations, or institutions - that cause a foreign company to be
at a disadvantage against local firms. Hymer reasoned that the advantages must be
economies of scale, superior technology, or superior knowledge in marketing,
management, or finance. Foreign direct investment takes place because of these
product and factor market imperfections, which enable the multinational enterprise
to operate more profitably in foreign markets than can local competitors.
This theory suggests that firms that use FDI as an internationalization strategy tend
to control certain resources and capabilities that give them a degree of monopoly
power relative to foreign competitors. The advantages that arise from this monopoly
power enable the MNE to operate foreign subsidiaries more profitably than the local
firms that compete in those markets. A key assumption of the theory is that, to be
successful, an MNE must possess monopolistic advantages over local firms in
foreign markets. In addition, the firm must keep these advantages to itself by
internalizing them. These advantages are specific to the MNE rather than to the
location of its production, are owned by the MNE and not easily available to its
competitors. For example, South African firm SAB Miller, the second largest beer
brewer in the world, leverages a near monopoly in its home country, relying on
extensive international business expertise, and offering a unique line of beers to
customers around the world.
The most important monopolistic advantage is superior knowledge which includes
intangible skills possessed by the MNE that provide a competitive advantage over
local rivals in foreign markets. Superior, proprietary knowledge allows MNEs to
create differentiated products that provide unique value to customers.

3.2.8.4.

Internalization Theory:

This theory is an extension of the market imperfection theory. A firm has superior
knowledge, but due to inefficiency in external markets, the firm may obtain a higher
price for that knowledge by using tire knowledge itself rather than by selling it in
the open market. By investing in foreign subsidiaries for activities such as supply,
production, or distribution, rather than licensing, the company is able to send the

22
knowledge across borders while maintaining it within the firm. The expected result
is the firms ability to realize a superior return on the investment made to produce
this knowledge, particularly as the knowledge is embodied in various products or
services that are sold to customers.
Some scholars investigated the specific benefits that MNEs derive from FDI-based
entry. For example, when Procter & Gamble entered Japan, management initially
considered exporting and FDI. With exporting, P&G would have had to contract with
an independent Japanese distributor to handle warehousing and marketing of soap,
detergent, diapers, and the other products that P&G now sells in Japan. However,
because of trade barriers imposed by the Japanese Government, the strong market
power of local Japanese firms and the risk of losing control over its proprietary
company knowledge, P&G chose instead to enter Japan via FDI. P&G established its
own marketing subsidiary and, eventually, national headquarters in Tokyo. Such an
arrangement provided various benefits that P&G would not have received had it
entered Japan by contracting with Japanese distributors not owned by P&G.
This example reveals how MNEs internalize key business functions and assets within
the corporate organization. Internalization theory explains the process by which
firms acquire and retain one or more value- chain activities inside the firm,
minimizing the disadvantages of dealing with external partners and allowing for
greater control over foreign operations. It contrasts the costs and benefits of
retaining key business activities within the firm against arms-length foreign entry
strategies such as exporting and licensing, in which the firm contracts with external
business partners to perform certain value-chain activities. By internalizing foreignbased value-chain activities it is the firm, rather that its products, that crosses
international borders. For example, instead of procuring from foreign independent
suppliers, the MNE internalizes the supplier function by acquiring or establishing its
own facilities in the foreign market. Where one firm might contract with
independent foreign distributors to market its products abroad, the MNE internalizes
the marketing function by establishing or acquiring its own distribution subsidiary
abroad. The MNE is ultimately a vehicle for bypassing the bottlenecks and costs of
the international, inter-firm exchange of goods, materials, and workers. In this way,
the MNE replaces business activities performed in external markets with business
activities performed within its own internal market.
Knowledge is critical to the development, production, distribution, and sale of
products and services. Because competitors can easily acquire and use a firms
knowledge, firms .internalize their key knowledge by internationalizing via FDI
instead of other modes such as exporting. FDI allows management to control and
optimally use the firms proprietary knowledge in foreign markets.

3.2.9.

MODES OF FOREIGN INVESTMENT:

The modes of foreign investment are as follows:

23

Modes of Foreign Investment

Licensing
Management Contracts
Joint Ventures
Green field Investments
Acquisition
Strategic Alliances
Exporting
Franchising

Turnkey Contracts

3.2.9.1.

Licensing:

Licensing used to be regarded as a 'second-rate method of entry into a foreign

market. It is the most attractive entry method because of the nature of the market
or because of the resources or strategy of the firm. Although licensing is a relatively
esy frrti of entry, it iS controversial mainly because, overall, the transfer of
technology is from the richer economies to the poorer nations that dont have the
resources to develop or buy their own technology, or whose markets are so small
they wont justify doing it. Most companies decide to go the licensing road because
of the characteristics of the market itself. Some firms may look at the market and
because of the difficulties of the other more conventional forms of entry may decide
to pass it up altogether.
Benefits of Licensing for the Licensee
Licensing provides benefits to both parties. The licensor receives profits in addition
to those generated from operations in domestic markets. There are various ways in
which a license agreement can give the licensee the possibility of increasing
revenues and profits and of enlarging market share:
1) There is often a rush to bring new products onto the market. A license
agreement that gives access to technologies which are already established or
readily available can make it possible for an enterprise to reach the market
faster.
2) Small companies may not have the resources to conduct the research and
development necessary to provide new or superior products. A license

24
agreement can give an enterprise access to technical advances that would
otherwise be difficult for if to obtain.
3) A license can also be necessary for the maintenance and development of a
market position that is already well established but is threatened by a new
design or new production methods. The costs entailed in following events and
trends can be daunting and quick access to a new technology through a license
agreement may be the best way to overcome this problem.
4) There may also be licensing-in opportunities which, when paired with the
companys current technology portfolio, can create new products, services and
market opportunities.
Limitations of Licensing for the Licensee
The limitations of licensing for the license are as follows:
1) The licensee may have made a financial commitment for a technology that is not
ready to be commercially exploited or that must be modified to meet the
licensees business needs.
2) An IP license may add a layer of expense to a product that is not supported by
the market for that product. It is fine to add new technology, but only if it comes
at a cost that the market will bear in terms of the price that can be charged.
Multiple technologies added to a product can result in a technology-rich product
that is too expensive to bring to market.
3) Licensing may create technology dependence on the supplier, who could choose
to not renew a license agreement, to negotiate license agreements with
competitors, to limit the markets in which you may use the licensed technology
or to limit the acts of exploitation allowed under the licensing agreement

3.2.9.2.

Management contracts

Under the management contract, the firm undertakes the management of a firm in
the foreign market. The firm providing the management know-how many not has
any equity stake in the enterprise being managed. In short, in a management
contract the supplier brings together a package of skills that will provide an,
integrated service to the client without incurring the risk and benefit of ownership.
Management contract could, sometimes, bring in additional benefits for the
managing company. It may obtain the business of exporting or selling otherwise of
the products of the managed company or supplying the inputs required by the
managed company. Some Indian companies - Tata Tea, Harrisons Malayalam
and AVT - have contracts to manage a number of plantations in Sri Lanka. Tata Tea
also has a joint venture in Sri Lanka namely Estate Management Services Pvt. Ltd.

3.2.9.3.

Joint Ventures:

Joint venture is a venture that is jointly owned and operated by two or more firms.
Many firms penetrate foreign markets by engaging in a joint venture with firms that
reside in those markets. For example, Xerox Corp and Fuji Co. engaged in a joint
venture that allowed Xerox Corp to penetrate the Japanese market.

25
Joint ventures tend to be relatively lower-risk operations because the risks are
shared by individual partner. Each party to these ventures contributes capital,
equity, or assets. Ownership of the joint venture need not be a 50-50 arrangement
and, indeed, percentage of ownership ranges according to the proportionate
amounts contributed by each party to the enterprise. Some countries stipulate the
relative amount of ownership allowable to foreign firms in joint ventures.
Types of Joint Venture
Joint ventures are common within industries and in various countries. But they are
specially useful or entering international markets. From the point of view of Indian
organizations, the following types of joint ventures are possible.
1)
2)
3)
4)
5)

Between
Between
Between
Between
Between

two firms
two firms
an Indian
an Indian
an Indian

in one industry,
across different industries,
firm and a foreign company in India,
firm and a foreign company in that foreign country, and
firm and a foreign company in a third country.

Benefits of Joint Venture

Following are the benefits of joint ventures:
1) Provide companies with the opportunity to gain new capacity and expertise.
2) Allow companies to enter related businesses or new geographic markets or
gain new technological knowledge.
3) Access to greater resources, including specialized staff and technology.
4) Sharing of risks with a venture partner.
5) Joint ventures can be flexible. For example, a joint venture can have a limited
life span and only cover part of what you do, thus limiting both your
commitment and the business exposure.
6) In the era of divestiture and consolidation, JVs offer a creative way for
companies to exit from non-core businesses.
7) Companies can gradually separate a business from the rest of the
organization and eventually, sell it to the other parent company. Roughly 80%
of all joint ventures end in a sale by one partner to the other.
Limitations of Joint Ventures
Following are the limitations of joint ventures:
1) It takes time and effort to build the right relationship and partnering with
another business can be challenging. Problems are likely to arise if:
i.
The objectives of the venture are not 100 per cent clear and
communicated to everyone involved.
ii.
There is an imbalance in levels of expertise, investment or assets
brought into the venture by the different partners.
2) Different cultures and management styles result in poor integration and cooperation.

26
3) The partners dont provide enough leadership and support in the early
stages.
4) Success in a joint venture depends on thorough research and analysis of the
objectives.

3.2.9.4.

Greenfield Investment:

A Greenfield Investment is the investment in a manufacturing, office, or other

physical company-related structure or group of structures in an area where no
previous facilities exist. The name comes from the idea of building a facility literally
on a "green" field, such as farmland or a forest. Overtime the term has become
more metaphoric.
Greenfield Investing is usually offered as an alternative to another form of
investment, such as mergers and acquisitions, joint ventures, or licensing
agreements. Greenfield Investing is often mentioned in the context of Foreign Direct
Investment.
A related term to Greenfield Investment which is becoming popular is Brownfield
Investment, where a site previously used for a "dirty" business purpose, such as a
steel mill or oil refinery, is cleaned up and used for a less polluting purpose, such as
commercial office space or a residential area.
A form of foreign direct investment where a parent company starts a new venture in
a foreign country by constructing new operational facilities from the ground up. In
addition to building new facilities, most parent companies also create new long-term
jobs in the foreign country by hiring new employees.
Developing countries often offer prospective companies tax-breaks, subsidies and
other types of incentives to set up green field investments. Governments often see
that losing corporate tax revenue is a small price to pay if jobs are created and
knowledge and technology is gained to boost the country's human capital.
Benefits of Greenfield Investment
Following are the benefits of Greenfield investment:
1)
2)
3)
4)
5)

Provides maximum design flexibility to meet project requirements,

New facility will reduce required maintenance,
Can be designed to meet current and future needs,
Opportunity to improve corporate image,
Suitable for either lease or own option.

Limitations of Greenfield Investment

Following are the limitations of Greenfield investment:
1) Some sites are not fully developed and have additional development costs
such as headworks costs for sewer and water,
'
2) Council approval time frames may be longer for new sites,

27
3) High demand of industrial sites may mean that sites available have
difficulties (slope, ground conditions).

3.2.9.5.

Acquisitions:

Acquisitions is acquiring or purchasing an existing venture. It is one of the easy

means of expanding a business by entering new markets or new product areas. An
entrepreneur must be careful in structuring the payment so that he will not be
financially overburdened. He must create a scope for phase wise payments so that
the company generates funds to pay. An acquisition strategy is based upon the
assumption that companies for potential acquisition will be available, but if the
choice of companies is limited, the decision may be taken on the basis of
expediency rather than suitability. The belief that acquisitions will be a time-saving
alternative to waiting for organic growth to take effect may not prove to be true in
practice. It can take a considerable amount of time to search and evaluate possible
acquisition targets, engage in protracted negotiations and then integrate the
acquired company into the existing organization structure.
Benefits of Acquisitions
Following are the benefits of acquisitions:
1) Buying an established business is always advantageous. If it is already
profitable the entrepreneur needs to keep up the continuity.
2) Familiarly with line of activity, region, market will make it easier to take
advantage of acquisition.
3) Existing distributors, dealers, traders can be made most use of due to
additional quantum^output on account of acquisition.
4) The method of expansion costs lower than other methods.
5) The knowledge, skills and expertise of existing employees will prove to be
very beneficial to the company.
Limitations of Acquisitions
Following are the limitations of acquisitions:
6) Many companies on sale are poor performers having outdated technology
and low morale employees.
7) The location, equipments and layout factors cannot be changed and hence
may be problematic.
8) Often when owners change, some of the key employees leave the job thus
creating void. This could be mere, problematic in high-tech areas.
9) Companies sell their old firms at inflated rates more due to land values than
due to high technology capabilities and pending orders.

28

3.2.9.6.

Strategic Alliances:

A Strategic Alliance is a formal relationship between two or [ore parties to pursue a

set of agreed upon goals or to meet a critical business need while remaining
independent organizations.
Partners may provide the strategic alliance with resources such as, products,
distribution channels, manufacturing capability, project funding, capital equipment,
knowledge, expertise, or intellectual property. The alliance is a co-operation or
collaboration which aims for a synergy where each partner hopes that the benefits
from the alliance will be greater than those from individual efforts. The alliance
often involves technology transfer (access to knowledge and expertise), economic
specialization, shared expenses and shared risk. Non-equity strategic alliances,
equity strategic alliances, and joint ventures are the three basic types of strategic
alliances.
Benefits of Strategic Alliance
The benefits of strategic alliance includes:
1) Allowing each partner to concentrate on activities that best match their
capabilities.
2) Learning from partners and developing competences that may be more
widely exploited elsewhere.
3) Adequency a suitability of the resources and competencies of an organization
for it to survive.
Limitations of Strategic Alliance
Following are the limitations of strategic alliance:
1) Implementing and managing a strategic alliance may be difficult because
each alliance partner has a different way of operating.
2) Mistrust could occur, particularly when competitive or proprietary information
is involved.
3) The alliance partners could become more dependent on each other, making it
difficult to operate again as separate entities if required.

3.2.9.7.

Exporting:

Entrance into an export market frequently begins casually, with the placement of an
order by a customer 4 overseas. At other times, an enterprise sees a market
opportunity and actively decides to take its products or services abroad. A firm can
be either a direct or an indirect exporter. As a direct exporter, it sees to all phases of
the sale and> transmittal of the merchandise. In indirect exporting, the exporter
hires the expertise of someone else to facilitate the exchange. This intermediary is,
of course, happy to oblige for a fee. There are several types of intermediaries;
manufacturers export agents, who sell the companys product overseas;
manufacturers representatives, who sell the products of a number of exporting

29
firms in overseas markets; export commission agents, who act as buyers for
overseas markets; export commission agents, who act as buyers for overseas
customers and export merchants, who buy and sell on their own for a variety of
markets.
Sales contacts within the foreign market are made through personal meetings,
letters, cables, telephone calls or international trade fairs. Some of these trade
expositions take unusual forms; e.g., in an attempt to promote the sale of U. S.
products in Japanese markets, the Japanese government established a traveling
trade show on a train.
Benefits of Exporting
The prime benefit of exporting is that it involves very little risk and low allocation of
resources for the exporter, who is able to use domestic production toward foreign
markets and thus increase sales and reduce inventories.
1) Increased Sales and Profits: Selling goods and services to a market, the
company never had before, boost sales and increases revenues. Additional
foreign sales over the long-term, once export development costs have been
covered, increase overall profitability.
2) Enhance
Domestic
Competitiveness:
Most
companies
become
competitive in the domestic market before they venture in the international
arena. Being competitive in the domestic market helps companies to acquire
some strategies that can help them in the international arena.
3) Gain Global Market Shares: By going international, companies will
participate in the global market and gain a piece of their share from the huge
international marketplace.
4) Diversification: Selling to multiple markets allows companies to diversify
their business and spread their risk. Companies will not be tied to the
changes of the business cycle of domestic market or of one specific country.
5) Lower per Unit Costs: Capturing an additional foreign market will usually
expand production to meet foreign demand. Increased production can often
lower per unit costs and lead to greater use of existing capacities.
6) Compensate for Seasonal Demands: Companies whose products or
services are only used at certain seasons domestically may be able to sell
their products or services in foreign markets during different seasons.
7) Create Potential for Company Expansion: Companies who venture into
the exporting business usually have to have a presence or representation in
the foreign market. This might require additional personnel and thus lead to
expansion.
8) Sell Excess Production Capacity: Companies who have excess production
for any reason can probably sell their products in a foreign market and not be
forced to give deep discounts or even dispose of their excess production.
9) Gain New Knowledge and Experience: Going international can yield
valuable ideas and information about new technologies, new marketing

30
techniques and foreign competitors. The gains can help a companys
domestic as well as foreign businesses.
10)
Expand Life Cycle of Product: Many products go through various
cycles namely introduction, growth, maturity and declining stage that is the
end of their usefulness in a specific market. Once the product reaches the
final stage, maturity in a given market, the same product can be introduced
in a different market where the product was never marketed before.
Limitations of Exporting
While the benefit of exporting by far outweigh the limitations, small and medium
size enterprises, especially face some challenges when venturing in the
international marketplace:
1) Extra Costs: Because it takes more time to develop extra markets and the
pay back periods, are longer, the up-front costs for developing new
promotional materials, allocating personnel to travel and other administrative
costs associated to market the product can strain the meager financial
resources of small size companies.
2) Product Modification: When exporting, companies may need to modify
their products to meet foreign countrys safety and security codes and other
import restrictions. At a minimum, modification is often necessary to satisfy
the importing countrys labeling or packaging requirements.
3) Financial Risk: Collections of payments using the methods that are
available (open-account, pre-payment, consignment, documentary collection
and letter of credit) are not only more time-consuming than for domestic
sales, but also more complicated. Thus, companies must carefully weigh the
financial risk involved in doing international transactions.
4) Export Licenses and Documentation: Though the trend is towards less
export licensing requirements, the fact that some companies have to obtain
an export license to export their goods makes them less competitive. In many
examples, the documentation required to export, is more involved, than for
domestic sales.
5) Market Information: Finding information on foreign markets is
unquestionably more difficult and time- consuming than finding information
and analyzing domestic markets. In less developed countries, e.g., reliable
information on business practices, market characteristics and cultural barriers
may be unavailable.

3.2.9.8.

Franchising

Franchising refers to the methods of practicing and using another persons

philosophy of business. The franchisor grants the independent operator, the right to
distribute its products, techniques and trademarks for a percentage of gross
monthly sales and a royalty fee. Various tangibles and intangibles such as national
or international advertising, training, and other support services are commonly
made available by the franchisor. Agreements typically last from five to thirty years,

31
with premature cancellations or terminations of most contracts bearing serious
consequences for franchisees.
Benefits of Franchising
Following are the benefits of franchising:
1) The advantages accruing to the franchisor are increased revenues and
expansion of its brand-name identification and market reach.
2) The franchisor gives you support - usually including training, help setting up
the business, a manual telling you how to run the business and ongoing
advice.
3) It usually has exclusive rights in the territory. The franchisor wont sell any
other franchises in the same region.
4) Financing the business may be easier. Banks are sometimes more likely to
lend money to buy a franchise with a good reputation.
5) Risk is reduced and is shared by the franchisor.
6) If one have an existing customer base they will not have to invest time
looking to set one up.
7) Relationships with suppliers have already been established.
Limitations of Franchising
Following are the limitations of franchising:
1) It is difficult to coping with the problems of assuring quality control and
operating standards.
2) Franchise contracts should be written carefully and provide recourse for the
franchising firm, should the Franchisee not comply with the terms of the
agreement.
3) Other difficulties with franchises come with their need to make slight
adjustments or adaptations in the standardized product or service. For
example, some ingredients in restaurant franchises may need to be adapted
to suit the tastes of the local clientele, which may differ from those of the
original customers,
4) Costs may be higher than you expect. As well as the initial costs of buying
the franchise, you pay continuing royalties and you may have to agree to buy
products from the franchisor.
5) The franchise agreement usually includes restrictions on how you run the
business. It might not be possible to make changes to suit local market.
6) The franchisor might go out of business or change the way they do things.
7) Other franchisees could give the brand a bad reputation.
8) Reduced risk means you might not generate large profits.

32

3.2.9.9.

Turnkey Contracts:

Turnkey contracts are common in international business in the supply, erection and
commissioning of plants, as in the case of oil refineries, steel mills, cement and
fertilizer plants, etc.; construction projects as well as franchising agreements.
A turnkey project is a contract under which a firm agrees to fully design, construct
and equip a manufacturing/business/service facility and turn the project over to the
purchaser when it is ready for operation for remuneration. The form of remuneration
includes:
1) A fixed price (firm plans to implement the project below this price)
2) Payment on cost plus basis (i.e., total cost incurred plus profit)
This form of pricing allows the company to shift the risk of inflation/enhanced costs
to the purchaser.
One of the major benefit of turnkey projects is the possibility for a company to
establish a plant and earn profits in a foreign country especially in which foreign
direct investment opportunities are limited and lack of expertise in a specific area
exists.
Potential limitations of a turnkey project for a company include risk of revealing
companies secrets to rivals, and takeover of their plant by the host country. By
entering a market with a turnkey project proves, that a company has no long-term
interest in the country which can become a disadvantage if the country proves to be
the main market for the output of the exported process.

3.2.10. COSTS AND BENEFITS OF FDI:

When direct investment flows from one country to another, it creates benefits both
for the home country an e host country. At the same time, it involves some costs
too. Thus, when a firm decides to make FDI, it takes into account the benefits and
costs to be accrued to not only 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.

3.2.10.1.

Benefits to Host Country:

The benefits of host country are as follows:

1) Availability of Scarce Factors of Production: FDI helps attain a proper
balance among 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. It brings in scarce foreign exchange that activates the domestic

33

2)

3)

4)

5)

sayings that would not have been put into investment in absence of the
availability of foreign exchange.
Improvement in the Balance of Payments: FDI helps improve the
balance of payments of the host country. 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 those items that were being imported earlier.
Building of Economic and Social Infrastructure: When the foreign
investors invest in sectors such as the basic economic infrastructure, social
infrastructure, financial markets and the marketing system, the host country
is able to develop a support system that is necessary for rapid
industrialization. Even if there is no investment in these sectors, the very
presence of foreign investors in the host, country creates a multiplier effect
and the support system develops automatically.
Fostering of Economic Linkages: Foreign firms have forward and
backward linkages. They make demand for various inputs that in turn helps
develop the input-supplying industries which is known as crowding-in effect.
They employ labor force and so help raise the income of the employed people
that in turn raises the demand and industrial production in the country.
Strengthening of Government Budget: The foreign firms are a source of
tax income for the government. They pay not only income tax, but tariff on
their import as well. At the same time, they help reduce the governmental
expenditure requirements through supplementing the governments
investment activities. All this eases the burden on the national budget.

3.2.10.2.

Benefits to Home Country:

The benefits of home country are as follows:

1) Creates New Employment: FDI benefits the home country with the
creation of employment. It also assists in ensuring the workers are paid
better salaries. This allows them to have an access to an improved lifestyle as
well as more facilities. The manufacturing and production sector is greatly
developed in the home country due to FDI investment. This increase in new
industries is beneficial creating new employment.
2) New Technology: Foreign direct investment benefits the host country
through introducing advanced skills and technology. New research will be
conducted in that home country as the international organization looks for
methods of enhancing its services. This leads to better technology that can
be applied in other parts of the nation for further development j
3) Improves Export: The other vital advantage of FDI to the home country is
that it enables these nations to enhance their export resources. Furthermore,
research shows that nations who get FDI from other international
organizations usually have lower interest rates. This means that their
exported products are much cheaper and thus enhances export.

34
4) Increases Income: Income generated through taxation is increased by FDI
investment. Actually, FDI plays an important role with regards to the increase
in productivity of home countries. It improves the local economy and living
standards, as well,
5) Improved Political Relations: FDI is a complement to foreign aid; it helps
develop closer political ties between the home country and the host country
which is beneficial for both the countries.

3.2.10.3.

Cost to Host Country:

The costs of host country are as follows:

1) Adverse Effects on Competition: The new foreign subsidiaries may grow
to have more economic power and more attractively priced products than the
host country companies.
2) Adverse Effects on Balance-of-Payments: If the foreign subsidiary
imports large quantities - this contributes to the home country having a
balance-of-payments deficit.
3) Adverse Effects on Natural Resources; Raw materials are exploited
keeping in view the interest of the home country that is sometimes
detrimental to the interest of the host country.
4) No Employment Opportunities: As far as employment of locals is
concerned, the MNCs normally show reluctance to train the local people.
Technology being normally capital-intensive does not assure larger
employment.
5) National Sovereignty and Autonomy
i).
Concern about key decisions can affect the host country economy.
ii).
Tear seems to be that if foreigners hold assets - they can somehow
hold the country to ransom - depends on the amount:
a)
A small amount may result in the foreign company being
a bully.
b)
A large amount means a foreign company is vulnerable
and needs to cooperate.
iii).
Sometimes, the manufacturing processes followed by the foreign
investors do not abide by the pollution norms or by the norms
regarding optimal use of the natural resources or the norms regarding
location of industries.

3.2.10.4.

Cost to Home Country:

The costs of Home Country are as follows:

a) Undesired Outflow of Factors of Production: The cost accruing to the
home country is only little. However, it cannot be denied that making of
investment 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 countrys interest.

35
b) Possibility of Conflict with the Host-Country Government: 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
country. This leads to a tussle between the host government and the home
government which may have a deleterious effect on bilateral relations.
c) Home Country Trade: Home country trade position may deteriorate if the
FDI results on low; cost goods being brought back to the home country displacing home country goods.
For examples, a Canadian textile company moving clothing operation to Latin
America results in textile workers in Canada losing their jobs, Gildan T-shirts
in Honduras, Nicaragua, Haiti and the Dominican Republic.

3.3. FOREIGN PORTFOLIO INVESTMENT

3.3.1. MEANING OF FOREIGN PORTFOLIO
INVESTMENT:
Foreign portfolio investment means a grouping of investment assets that focuses on
securities from foreign markets rather than domestic ones. A foreign portfolio is
designed to give the investor exposure to growth in emerging and international
markets and provide diversification.
Foreign portfolio investments allow investors to further diversify their assets by
moving away from a domestic- only portfolio. This type of portfolio can carry
increased risk due to potential economic instability stemming from emerging
markets, but can also bring increased stability through investments in industrialized
and more stable markets.
Due to the integration of global financial markets, many companies already have
operations in more than one country. In other words, international portfolio
investment means the purchase of stocks, bonds, and money market instruments
by foreigners for the purpose of realizing a financial return which does not result in
foreign management, ownership, or legal control. Portfolio investment is part of the
capital account on the balance of payments statistics.
Some examples of portfolio investment are:
Purchase of shares in a foreign company.
Purchase of bonds issued by a foreign, government.
Acquisition of assets in a foreign country.

36

3.3.2. INTERNATIONALIZING THE DOMESTIC

PORTFOLIO
The basic principles of traditional domestic portfolio theory to aid in the
identification of the incremental changes introduced through, international
diversification, the following theories show how diversifying the portfolio
internationally alters the potential set of portfolios available to the inventor.
Optimal Domestic Portfolio
Classic portfolio theory assumes a typical investor is risk-averse. This means that an
investor is willing to accept some risk but is not willing to bear unnecessary risk.
The typical investor is, therefore, in search of a portfolio that maximizes expected
portfolio return per unit of expected portfolio risk.
Optimal Domestic Portfolio Construction
The domestic investor may choose among a set of individual securities in the
domestic market. The near infinite set of portfolio combinations of domestic
securities form the domestic portfolio opportunity set shown in the following figure
3.3. The set of portfolios formed along the extreme left edge of the domestic
portfolio opportunity set is termed the efficient frontier. It represents the optimal
portfolios of securities that possess the minimum expected risk for each level of
expected portfolio return. The portfolio with the minimum risk among all those
possible the Minimum Risk Domestic Portfolio (MRDP).
Investor may choose a portfolio of assets enclosed by the domestic portfolio
opportunity set. The Optimal domestic portfolio is found at DP, where the capital
market line is tangent to the domestic portfolio opportunity set. The domestic
portfolio with the minimum risk is designated MRDP

37

Expected return of portfolio, RP

Optimal domestic portfolio, DP

Capital Market line (domestic)

DP
RDP
Minimum Risk Domestic Portfolio (MRDP)
MRDP

Rf

Domestic portfolio opportunities set

Expected risk of portfolio, P

DP

The individual investor will search out the optimal Domestic Portfolio (DP), which
combines the risk-free asset and a portfolio of domestic securities found on the

38
efficient frontier. He or she begins with the risk-free asset with return of R f (and zero
expected risk) and moves out along the security market line until reaching portfolio
DP. This portfolio is defined as the optimal domestic portfolio because it proves out
info risky space at the steepest slope - maximizing the slope of expected portfolio
return over expected risk - while still touching the opportunity set of domestic
portfolios. This line is called the capital market line and portfolio theory assumes an
investor who can borrow and invest at the risk-free rate can move to any point
along this line.
Note that the optimal domestic portfolio is not the portfolio of Minimum Risk (MRDP).
A line stretching from the risk-free asset to the minimum risk domestic portfolio
would have a lower slope than the capital market line and the investor would not be
receiving as great an expected return (vertical distance) per unit of expected risk
(horizontal distance) as that found at DP.

3.3.3. INTERNATIONAL PORTFOLIO

DIVERSIFICATION
The following figure shows the impact of allowing the investor to choose among an
internationally diversified set of potential portfolios. The internationally diversified
portfolio opportunity set shifts leftward of the purely domestic opportunity set. At
any point on the' efficient frontier of the internationally diversified portfolio
opportunity set, the investor can find a portfolio of lower expected risk for each
level of expected return.

39

Expected return of portfolio, RP

Internationally diversified portfolio opportunity set

DP
Domestic portfolio opportunities set
RDP

Expected risk of portfolio, P

DP
Rf

40
It is critical to be clear as to exactly why the internationally diversified portfolio
opportunity set is of lower expected risk than comparable domestic portfolios. The
gains arise directly from the introduction of additional securities and/or portfolios
that are of less than perfect correlation with the securities and portfolios within the
domestic opportunity set.
Internationally Diversified Portfolio Opportunity Set
Addition of internationally diversified portfolios to the total opportunity set available
to the investor shifts the total portfolio opportunity set left, providing lower
expected risk portfolios for each level of expected portfolio return
For example, Sony Corporation is listed on the Tokyo Stock Exchange. Sonys share
price derives its value from both the individual business results of the firm and the
market in which it trades. If either or both are not perfectly positively correlated to
the securities and markets available to a U.S. based investor, then that investor
would observe the opportunity set shift shown in above figure.
Optimal International Portfolio

41

Increased return of optimal portfolio

Risk reduction of optimal portfolio

42
Gains from International Portfolio Diversification

Capital

The investor can now choose an optimal portfolio that combines the same risk-free
asset as before with a portfolio from the efficient frontier of the internationally
diversified portfolio opportunity set. The optimal international portfolio, IP, is again
found by locating that point on the capital market line (internationally diversified)
which extends from the risk-free asset return of R| to a point of tangency along the
internationally diversified efficient frontier.
The benefits of international diversification are now obvious. The investors optimal
portfolio IP possesses both higher expected portfolio return (R IP > RDP) and lower
expected portfolio risk ( IP<DP ) than the purely domestic optimal portfolio. The
optimal international portfolio is superior to the optimal domestic portfolio.

3.3.3.1.
Rationale for International Portfolio
Diversification
The systematic risk of a domestically diversified portfolio of securities arises from
the dependence of all industries in the economy on a common set of
macroeconomic factors and uncertainties, e.g., weather, political events, economic
policies, cultural influences, etc. This dependence generates positive correlation
between security returns of a domestically diversified portfolio. Thus, purely
domestic diversification puts a limit on risk reduction.
It is in this context that an internationally diversified portfolio becomes attractive to
investors. A portfolio that incudes securities from different countries would be able
to achieve further risk reduction than a domestic portfolio. This is possible because
different countries may have different business and economic environments on
account of diverse economic policies and programs followed in different countries
As a result, there may not be much positive correlation between security returns
from different countries. As securities from different countries are added to the
investment portfolio of an investor, the risk of the portfolio gets reduced further
because the returns from such foreign securities do not have much positive
correlation with those from the domestic securities in the portfolio.
Thus, diversification of a portfolio across national boundaries becomes an effective
strategy for risk reduction in investment. This is the primary rationale for
international portfolio diversification.

3.3.3.2.
Barriers to International Portfolio
Investment
It is an established fact that the international diversification of portfolio is gainful.
But there are also some barriers that mar an optimal international diversification of
portfolio. These problems are broadly:

Dom

43
1) Unfavorable Exchange Rate Movement: An investor cannot ignore the
possibility of exchange rate changes. In a floating-rate regime, the exchange
rate changes are a normal phenomenon. A change influences the value of the
foreign portfolio as well as the earnings therefrom both directly and indirectly.
Suppose an American investor invests in Indian securities. If the Indian rupee
depreciates, the value of Indian securities in terms of U.S. dollars will be
lower. At the same time, the amount of earning too shall be lower in terms of
U.S. dollars. This may be said to be a direct impact of the exchange rate
changes. Exchange rate changes have an indirect impact on international
portfolio too. Since the foreign exchange market and the securities market
are closely interlinked, any depreciation of domestic currency, the rupee in
our example, will have an adverse effect on the security market index. The
value of the securities in which the American investor has invested will be
lower in rupee terms also.
2) Frictions in International Financial Market: There are market frictions
manifesting in Governmental controls varying tax laws and explicit and
implicit transaction costs. Governments often try to administer international
financial flows through different forms of control mechanisms, such as
multiple exchange rates, taxes on international flows, and restrictions on the
outflow of funds. If such controls persist, foreign investment inflow is
hampered despite ample returns/low risk.
Again varying tax laws and varying tax rates come in the way of international
investment. In many countries, capital gains, dividend, and interest income
are taxed and there is tax also on financial transactions. If the rates are high,
post-tax returns are obviously low. There are, of course, treaties to help in
avoiding double taxation, even then taxes limit the scope of international
portfolio investment.
Yet again, there are varieties of implicit and explicit transaction costs, such as
trading commission/fees and bid-ask spreads, etc. In developed countries,
transaction costs are often less cumbersome. But in emerging market
economies, they figure large. Moreover, transaction cost per unit falls with
growing size of transaction, but the small investors do not get this advantage.
3) Manipulation of Security Prices: It is true that in a perfectly competitive
financial market, no investor can influence the market price of securities. But
in the real world, it is the Government and also the big brokers that influence
the security prices. The Government influences them through its monetary
and fiscal policies. It can change interest rates, tax rates, etc. It can change
the regulatory provisions. The manipulation is often large when the public
sector financial institutions and banks hold big chunk of the securities traded
on the stock exchange. In such cases, the asset portfolio lacks the desired
liquidity with the result that the foreign portfolio investment becomes a costly
and difficult proposition.
4) Unequal Access to Information: It is the wide cross-cultural differences
that inhibit international portfolio investment. Accounting practices and the
disclosure system vary among countries. The language varies from one

44
country to the other. As a result, it is difficult for the international investors to
collect information. In absence of desired information, It is difficult for them to
act rationally.

3.3.3.3.

Home Country Bias

Home country bias is a term used to describe investment behavior whereby

investors display a tendency to hold a large percentage of their assets in
investments within their borders. This bias may have a positive net effect during
periods when their home country is growing faster than foreign competitors and/or
their currency appreciating relative to other currencies. However, this bias may lead
to missed opportunities if foreign competitors are gaining world market share due to
faster economic growth and/or their currencies are appreciating versus the home
currency.
One would expect that most investors, particularly institutional Und professional
investors, .would be aware of the opportunities offered by international investing.
Yet in practice, investor portfolios notoriously overweight home-country stocks
compared to a neutral indexing strategy and underweight, or even completely
ignore, foreign equities. This has come to be known as the home-country bias.
Despite a continuous increase in cross- border investing, home-country bias still
dominates investor portfolios.
Many studies have demonstrated the gain from international diversification.
However, recent research has indicated that investors seem to greatly favor
domestic assets and invest much less in foreign assess than one would expect given
the expected gains from diversification.
The home bias enigma is the most puzzling investor behavior anomaly uncovered
lately. It appears that investors under-diversify. Despite the clear theoretical and
empirical demonstrations that diversification can improve the risk-return trade-offs
of their portfolios, investors impose restrictions on diversification that is do not
diversify enough. Individual and professional investors prefer to hold, and tilt their
portfolio weights towards, stocks of companies that are familiar and
(geographically) close to them.
The home bias was first detected in international finance, where it is referred to as
the home country bias. Home-country bias, or simply home bias, usually refers to a
situation in which the proportion of foreign equities held by domestic investors in
their portfolios is too small relative to the predictions of standard portfolio theory.
The extent to which equity portfolios are concentrated in equities of the investor's
domestic market is a notable feature of international portfolio investment and has
remained an important yet unresolved empirical puzzle in financial economics since
the 1970s. Since portfolio, theory is the foundation of asset pricing theory, the
empirical evidence that investors may not optimize along objective risk-return
tradeoffs as portfolio theory predicts has important implications for our
understanding of the way security prices are set.

45
Why do investors seem to have this bias in favor of securities of their home
country? There are several possible reasons - taxes, transaction costs, or something
else that is missing from the standard model of international investment. These
reasons are explained below:
Taxes: If home bias is due to taxes, then the tax on foreign securities would have to
be high enough to offset the higher return (or lower risk) expected from these
securities. However, taxes paid to foreign governments can usually be credited
against domestic taxes. Even if |here is some net increase in the tax paid op foreign
investment, it is unlikely that this increase could be high enough to discourage
foreign investment to the extent observed.
Transaction Costs: The cost associated with buying and selling foreign Securities
includes explicit monetary costs, like fees, commissions, and bid-ask spreads, and
implicit costs such as differences in regulations protecting investors, language
differences, and costs of obtaining information about foreign investment
opportunities. Familiarity with domestic assets and lower explicit costs of trading at
home may lead to home .bias.
One possibility is that the gains from international diversification have been
overstated. If countries tend to specialize in the production of certain goods and
services and trade with the rest of the world for other goods and services, it is
possible to imagine a situation where incomes fluctuate less than one might think
based on fluctuations in domestic production. As output fluctuates for certain
industries, relative prices change and this relative price change helps to smooth out
income fluctuations. For example, if the Philippines specialize in pineapple
production and bad weather reduces the harvest, pineapple prices rise due to the
reduction in supply. This price increase helps to cushion the fall in income related to
the poor harvest. In this manner, relative price changes may serve as a natural
hedge against output fluctuations, so that there is less income variability to be
reduced through diversification.

3.3.4. FACTORS AFFECTING FOREIGN PORTFOLIO

INVESTMENT
The desire by individual or institutional investors to direct foreign portfolio
investment to a specific country is influenced by the following factors:
1) Tax Rates on Interest or Dividends: Investors normally prefer to invest in
a country where the taxes on interest or dividend income from investments
are relatively low. Investors assess their potential after-tax earnings from
investments in foreign securities.
2) Interest Rates: Portfolio investment can also be affected by interest rates.
Money tends to flow to countries with high interest rates, as long as the local
currencies are not expected to weaken.
3) Exchange Rates: When investors invest in a security in a foreign country,
their return is affected by:

46
a.
b.

The change in the value of the security, and

The change in the value of the currency in which the security is
denominated.

If a countrys home currency is expected to strengthen, foreign investors may be

willing to invest in the countrys securities to benefit from the currency movement.
Conversely, if a countrys home currency is expected to weaken, foreign investors
may decide to purchase securities in other countries. In a period such as 2006, U.S.
investors that invested in foreign securities benefited from the change in exchange
rates. Since the foreign currencies strengthened against the dollar over time, the
foreign securities were ultimately converted to more dollars when they were sold at
the end of the year.

3.3.5. MODES OF FOREIGN PORTFOLIO

INVESTMENT
There are different modes of foreign portfolio investment. An investor has to findout which one of them is more suitable. Some of the common modes are:
1) Buying foreign securities or depository receipts directly from the
domestic stock exchange if such securities are listed there;
i).
Portfolio Equity: This is defined as investment which is made for the
purpose of securing income or capital gains growth rather than to gain
control of an enterprise. Such investments would normally be held in a
range of companies with the aim of diversifying and reducing risk.
ii).
Portfolio Bonds: These are similar to portfolio equity, in that the aim
is to secure a financial return rather to gain control of an enterprise
and that investors would normally hold bonds in a range of companies.
Like portfolio equity they are bought and sold on a secondary market.
The difference is that they are a loan rather than a share in the
company. Bond holders thus receive a predetermined rate of interest
rather than a dividend payment which depends on the profit
performance of the company.
2) Approaching International Mutual Funds: Alternatively, an investor buys
the shares of an internationally diversified mutual fund. There are many
open-ended mutual funds that trade in international securities on behalf of
the individual investor. They prefer liquidity and try to allocate portfolio in
proportion to the market capitalization of the more important stock
exchanges. The mutual funds are normally no-load funds, but some of them
charge upfront fees.
3) Approaching Closed-End Country Funds: The closed-ended funds are
different from the open-ended funds in that the former make investment
initially in international securities and issue shares against the portfolio. They
try to avoid any change in their investment portfolio depending upon the
changes in the response of the investors. Such closed-ended funds

47
experienced a hey-day in 1980s with the setting-up of Korea Fund. Now they
are popular.
4) Buying Directly The Securities Of Domestic Companies Having Global
Operation: An investor buys shares of domestic company that operates
internationally. It is, in fact, indirect way of participating in the global
economy. In this case, the investor does not have ample scope for reaping
diversification benefits insofar as the systematic risk cannot be reduced to
that extent.

3.3.6. ADVANTAGES OF FOREIGN PORTFOLIO

INVESTMENT
Economists suggest that the foreign portfolio investment (FPI) can benefit the real
sector of an economy in the following ways:
1) The inflow of FPI can provide a developing country non-debt creating source
of foreign investment. The developing countries are capital scarce. The
advent of portfolio investment can supplement domestic saving for improving
the investment rate. By providing foreign exchange to the developing
countries, FPI also reduces the pressure of foreign exchange gap for the
LDCs, thus making imports of necessary investment goods easy for them.
2) It is suggested by mainstream economists that increased inflow of foreign
capital increases the allocative efficiency of capital in a country. According to
this view, FPI, like FDI, can induce financial resources to flow from capitalabundant countries, where expected returns are low, to capital-scarce
countries, where expected returns are high. The flow of resources into the
capital-scarce countries reduces their cost of capital, increases investment,
and raises output. However, according to another view, portfolio investment
does not result in a more efficient allocation of capital, because international
capitalflows have little or no connection to real economic activity.
Consequently portfolio investment has no effect on investment, output, or
any other real variable with non-trivial welfare implications.
3) The most important way FPI affects the economy is through its various
linkage effects via the domestic capital market. According to the mainstream
view, one of the most important benefits from FPI is that it gives an upward
thrust to the domestic stock market prices. This has an impact on the priceearning ratios of the firms. A higher P/E ratio leads to a lower cost of finance,
which in turn can lead to a higher amount of investment. The lower cost of
capital and a booming share market can encourage new equity issues. A
higher premium in the new issues will be the inducing factor here. However,
it must be clarified that equity investment may not always lead to an
increase in real investment in the private sector. This is simply because most
stock purchases are on the secondary market rather than the purchase of
newly issued shares.
4) FPI also has the virtue of stimulating the development of the domestic stock
market. The catalyst for this development is competition from foreign

48
financial institutions. This competition necessitates the importation of more
sophisticated financial technology, adaptation of the technology to local
environment, and greater investment in information processing and financial
services.

3.3.7. DISADVANTAGES OF FOREIGN PORTFOLIO

INVESTMENT
It is an established fact that the international diversification of portfolio is gainful.
But there are also some limitations that mar an optimal international diversification
of portfolio. These limitations are as follows:
1) Unfavorable Exchange Rate Movement: An investor cannot ignore the
possibility of exchange rate changes. In a floating-rate regime, the exchange
rate changes are a normal phenomenon. A change influences the value of the
foreign portfolio as well as the earnings therefrom both directly and indirectly.
Suppose an American investor invests in Indian securities. If the Indian rupee
depreciates, the value of Indian securities in terms of U.S. dollars will be
lower. At the same time, the amount of earning too shall be lower in terms of
U.S. dollars. This may be said to be a direct impact of the exchange rate
changes. Exchange rate changes have an indirect impact on international
portfolio too. Since the foreign exchange market and the securities market
are closely interlinked, any depreciation of domestic currency, the rupee in
our example, will have an adverse effect on the security market index. The
value of the securities in which the American investor has invested will be
lower in rupee terms also.
2) Frictions in International Financial Market: There are market frictions
manifesting in Governmental controls, varying tax laws and explicit and
implicit transaction costs. Governments often try to administer international
financial flows through different forms of control mechanisms, such as
multiple exchange rates, taxes on international flows, and restrictions on the
outflow of funds. If such controls persist, foreign investment inflow is
hampered despite ample returns/low risk.
Again, varying tax laws and varying tax rates come in the way of
international investment. In many countries, capital gains, dividend, and
interest income are taxed and there is tax also on financial transactions. If
the rates are high, post-tax returns are obviously low. There are, of course,
treaties to help in avoiding double taxation, even then taxes limit the scope
of international portfolio investment.
Yet again, there are varieties of implicit and explicit transaction costs, such as
trading commission/fees and bid-ask spreads, etc. In developed countries,
transaction costs are often less cumbersome. But in emerging market
economies, they figure large. Moreover, transaction cost per unit falls with
growing size of transaction, but the small investors do not get this advantage.
3) Manipulation of Security Prices: It is true that in a perfectly competitive
financial market, no investor can influence the market price of securities. But

49
in the real world, it is the Government and also the big brokers that influence
the security prices. The Government influences them through its monetary
and fiscal policies. It can change interest rates, tax rates, etc. It can change
the regulatory provisions. The manipulation is often large when the public
sector financial institutions and banks hold big chunk of the securities traded
on the stock exchange. In such cases, the asset portfolio lacks the desired
liquidity with the result that the foreign portfolio investment becomes a costly
and difficult proposition.
4) Unequal Access to Information: It is the wide cross-cultural differences
that inhibit international portfolio investment. Accounting practices and the
disclosure system vary among countries. The language varies from one
country to the other. As a result, it is difficult for the international investors to
collect information. In absence of desired information, it is difficult for them to
act rationally.

3.4. INTERNATIONAL CAPITAL BUDGETING

3.4.1. CONCEPT OF INTERNATIONAL CAPITAL
BUDGETING:
Capital budgeting for multinational firms uses the same framework as domestic
capital budgeting. However, multinational firms engaged in evaluating foreign
projects face a number of complexities, many of which are not there in the domestic
capital budgeting process.
International capital budgeting is more complicated than domestic capital budgeting
because MNCs are typically large and capital intensive, and because the process
involves a larger number of parameters and decision variables. In general,
international capital budgeting involves a consideration of more risk than domestic
capital budgeting. But like domestic capital budgeting, international capital
budgeting involves the estimation of some measures or criteria that indicate the
feasibility or otherwise of a project (a capital budgeting evaluation measure) such
as the Net Present Value (NPV). However, certain factors that are not considered in
domestic capital budgeting should be taken into account in international capital
budgeting because of the special nature of FDI projects.
The estimation of NPV and similar criteria requires:
1) The identification of the relevant expected cashflows to be used for the
analysis of the proposed project and
2) The determination of the proper discount rate for finding the present value of
the cashflows.
International capital budgeting involves substantial spending (capital investment) in
projects that are located in foreign (host) countries, rather than in the home country
of the MNC. Foreign projects differ from purely domestic project with respect to a
number of factors - the foreign currency dimension, different economic indicators

50
(such as inflation) in different countries, and different risk characteristics with which
the MNC is not as familiar with as those pertaining to domestic projects. All these
differences lead to a higher level of risk in international capital budgeting than in
domestic capital budgeting.

3.4.2. FACTORS AFFECTING INTERNATIONAL

CAPITAL BUDGETING
The factors affecting international capital budgeting are as follows:
1) Blocked Funds: If funds are blocked or otherwise restricted can be utilized
in a foreign investment, the capital cost to the investor may be below the
local project construction costs. From the investors perspective, there is a
gain from activated funds equal to the difference between the face value of
those funds and the present value of funds if the next best thing is done with
them. This gain should be deducted from the capital cost of the project to find
the cost from the investors perspective
2) Amenities and Concessions Granted by Host Countries: While
governments do offer special financial aid or other kinds of help for certain
domestic projects, it is very common for foreign investments to carry some
sort of assistance. This may come in the form of low-cost land, income-tax
holidays for a stated number of years, exemption from or reduction in custom
duties on imported parts or raw materials (permanent or temporary),
exemption from, or preferential treatment of, tax withheld on net income,
concessionary loans (for initial investment and/or working capital purposes),
subsidized utility rates, and so on. Most of these benefits require no special
interest in the capital budgeting exercise, because they are, or should be,
already reflected in capital costs. But concessionary lending is problematic
since such financing will replace financing by the parent or from other higher
interest sources. However, with the APV technique, we can add a separate
term to include the subsidy. This is particularly important, since the special
concessionary loan will be available to the corporation but not directly to the
shareholders. This will make the appropriate cost of capital for foreign
investment projects differ from that for the domestic projects, which is what
happens in segmented capital markets.
3) Differing Rates of National Inflation: Long-term inflation rates - Differing
rates of national inflation and their potential effect on competitiveness most
be considered. Inflation will have the following effects on the value of the
project:
i).
It will impact the local operating cashflows both in terms of the prices
of inputs and outputs, and also in terms of the sales volume depending
on the price elasticity of the product.
ii).
It will impact the parents cashflow by affecting the foreign exchange
rates, and
iii).
It will affect the real cost of financing choices between foreign and
domestic sources of capital.

51
4) Political Risk Involved in Foreign Investment: Political Risk - This is
another factor that can significantly impact the viability and profitability of
foreign projects. Whether it be through democratic elections or as a result of
sudden developments such as revolutions or military coups, changes in a
countrys government can impact the attitude towards foreign investors and
investments. This can affect the future cashflows of a project in that country
in a variety of ways. Political developments may also affect the life and the
terminal value of foreign investments.
5) Exchange Rate Fluctuations: Foreign Currency Fluctuations - Another
added complexity in multinational capital budgeting is the significant effect
that fluctuating exchange rates can have on the prospective cashflows
generated by the investment. From the parents perspective, future cashflows
abroad have value only in terms of the exchange rate at the date of
repatriation. In conducting the analysis, it is necessary to forecast future
exchange rates and to conduct sensitivity analysis of the projects viability
under various exchange rate scenarios.
6) Subsidized Financing: In order to attract foreign investments in key
sectors, the governments of developing economies generally provide support
in the form of subsidy. Likewise, international agencies entrusted with the
responsibility of promoting cross-border trade sometimes offer financing at
below- K market rates. The value of the subsidized loan should be added to
that of the project while making the investment decision if the subsidized
financing is inseparable from the project. But if subsidized financing B|s
separable from a project, the additional value from the subsidized financing
should not be allocated to the r project. In such a case, the managers
decision is that so long as the subsidized loan is unconditional, it should be
accepted. If the MNC can use the proceeds of subsidized financing at a higher
rate in a comparable risk investment, it will lead to positive NPV to the firm.
7) Lost Exports: Another factor affecting the international capital budgeting is
the issue of lost exports arising out of engaging in a project abroad. Profits
from lost exports represent a reduction from the cashflows generated by
foreign project for each year of its duration. This downward adjustment in
cashflows may be total, partial or nil depending upon whether the project will
replace projected exports' or none of them.
8) International Diversification Benefits: Dispersal of investment in a
number of countries is likely to produce diversification benefits to the parent
companys shareholders. However, it would be difficult to quantify such
benefits as can be allocated to a particular project.
Generally, such non-quantifiable variables are ignored in capital budgeting
decision. However, in case of a marginal project or a project which is not
acceptable on its merits, this factor may be taken care of. Sometimes, a
marginal project may be found worthwhile when its beneficial diversification
effect on the overall pattern of cashflow generation by the MNC is taken into
consideration.

52
9) Host Government Incentives: If the host government offers incentives,
they should be included in the capital budgeting decisions. For example, if
the host government offers tax incentives or provides loans at subsidized
rates, the amount of gain on this account should be added to the operating
cash inflow.
10)
Difficulty in Estimating Terminal Value of Foreign Projects:
Terminal values - While terminal values of long-term projects are difficult to
estimate even in the domestic context, they become far more difficult in the
multinational context due to the added complexity from some of the factors
discussed above. An added dimension is that potential acquirers may have
widely divergent perspectives on their value of acquiring the terminal assets.
This is particularly relevant the assets are located in a country that is
economically segmented due to a host of restrictions on cross-border flow of
physical or financial assets.

3.4.3.

EVALUATION OF PROJECT

Once a firm has compiled a list of prospective investments, it uses capital budgeting
techniques to select from among them that combination of projects that maximizes
the firms value to shareholders. The theoretical framework involved in evaluation of
domestic projects is the same as for foreign projects and various considerations
influencing choice of a project within the country are the, same as those for projects
overseas. However, there are a host of factors which are unique to foreign
investments that make cross-border investment decisions complicated.
The basic steps involved in evaluation of a project are:
1) Determine net investment outlay;
2) Estimate net cashflows to be derived from the project over time, including an
estimate of salvage value;
3) Identify the appropriate discount rate for determining the present value of
the expected cashflows;
4) Apply NPV of IRR techniques to determine the acceptability or priority ranking
of potential projects.
This selection requires a set of rules and decision criteria that enables managers to,
determine, given an investment opportunity, whether to accept or reject it. It is
generally agreed that the criterion of net present value is the most appropriate one
to use since its consistent application will lead the company to select the same
investments the shareholders would make themselves, if they had the opportunity.

3.4.4. EVALUATION OF OVERSEAS INVESTMENT

PROPOSAL
The fundamental goal of the financial manager is to maximize shareholders wealth.
Shareholders wealth is maximized when the firm, out of a list of prospective

53
investments, selects a combination of those projects that maximize the companys
value to its shareholders. This selection process requires the financial manager to
discount the project cash flows at the firms weighted average cost of capital, or the
projects required rate of return, to determine the net present value. Alternatively,
the internal rate of return that equates project cash flows to the cost of the project
is calculated, There are several methods through which the projects can be
evaluated in capital budgeting like, payback period, internal rate of return,
profitability index but finance manager^ generally believe that the criteria of net
present value is the most appropriate in capital budgeting since it will help the
company to Select only those investments which maximize the wealth, of the
shareholders.

Approaches to project Evaluation

Discounted Cash Flow Analysis (DCF)

Adjusted Present Value Approaches (APV)

Net Present Value

Internal Rate of Return

The methods of capital budgeting is as follows:

3.4.4.1.
Evaluation of Overseas Investment
Proposal Using Discounted Cash Flow Analysis
(DCF)
Discounted cash; flow technique involves the use of the time value of money principle
to project evaluation. The two most widely used criteria of the discounted cash flow
technique are the net present value (NPV) and the internal rate of return (IRR). Both
the techniques discount the projects cash flow at an appropriate discount rate. The
results are then used to evaluate the projects based on the acceptance/ rejection
criteria developed by management,
1) Net Present Value (NPV): NPV is the most popular method and is defined as the
present value of future cash flows discounted at an appropriate rate minus the
initial net cash outlay for the projects. The discount rate used here is known as the
cost of capital. The decision criterion is to accept projects with a positive NPV and
reject projects which have a negative NPV.

54
The NPV can be defined as follows:
n

NPV =I 0 +
t=1

CF t
(1+ K )t

Where
I0 = Initial cash investment
CFt = Expected after-tax cash flows in year t.
K = Weighted average cost of capital
n = Life span of the project
The NPV of a project is the present value of all cash inflows, including those at the
end of the project s life, minus the present value of all cash outflows.
The decision criteria is to accept a project if NPV 0 and to reject if NPV<0
For example, to set the stage, let us assume that you are trying to decide whether
to undertake one of two projects. Project A involves buying expensive machinery
that produces a better product at a lower cost. The machines for project A cost
$1,000 and, if purchased, your anticipate that the project with produce cash flows of
$500 per year for the next five years. Project Bs machines are cheaper, costing
$800, but they produce smaller annual cash flows of $420 per year for the next five
years. We will assume that the correct discount rate is 12%.
Suppose we apply the NPV criterion to project A and B:
Year

Two Projects
Project A

Project B

-1,000

-800

50Q

420

500

420

500

420

500

420

500

420

NPV

802.39

714.01

Discount rate-12%
Both projects are worthwhile, since each has a positive NPV. If we have to choose
between the projects, then project A is preferred to project B because it has the
higher NPV.

55
Example 1; A project involves initial investment for $5,000,000. The net cash
inflow during the first, second, and the third year is expected respectively
$3,000,000, $3,500,000 and $2,000,000. At the end of fee third year, the scrap
value is indicated at $ 1,000,000. The risk-adjusted discount rate is 10 per cent.
Calculate NPV.
Solution:

t 1 +t 2+ t 3 I 0

3,000,000 3,500,000 2,000,000+1,000,000

+
+
5,000,000=$ 2,873,778
2
3
1.10
1.10
1.10

Project would be accepted because NPV is positive.

2) Internal Rate of Return (IRR): IRR is calculated by solving for r in the
following equation.
n

CF

(1+rt)t I 0=0
t =1

Where, r is the internal rate of return of the project.

The IRR method finds the discount rate which equates the present value of the cash
flows generated by the project with the initial investment or the rate which would
equate the present value of all cash flows to zero.
To illustrate this technique, the study assumes a firm is considering investing in a
project that has the following cash flows:
Year(t)

Expected After-Tax Net Cash flows,

C.F($)

(5,000)

800

900

1,500

1,200

3,200

CF = $(5,000) represents the net cost, or initial investment, that is required to

purchase the asset - the parentheses indicate that the cashflow is negative.
The IRR for above project is:

56

NPV =$ 5,000+

$ 800
$ 900
$ 1,500 $ 1,200 $ 3,200
+
+
+
+
1
1
1
1
1
1+ IRR 1+ IRR 1+ IRR 1+ IRR 1+ IRR
IRR=12.5%

A project is acceptable using IRR if its IRR is greater than the firms required rate of
return - i.e., IRR > r. Remember that the IRR represents the rate of return the firm
will earn if the project is purchased. So, simply stated, the project must earn a
return that is greater than the cost of the funds used to purchase it. In the example,
IRR = 12.5%, which is greater than r = 12%, so the project is acceptable.

3.4.4.2.
Evaluation of Overseas Investment
Proposal Using Adjusted Present Value Model
(APV)
THE APV model is a value additivity approach to-capital budgeting, i.e,, each cash
flow as a source of value is considered individually. Also, in the APV approach lach
bash flow is discounted at a rate of discount consistent with the risk inherent in that
cash flow. In equation from the APV approach can be written as:

1+ K

Xt

APV =I 0 +
t=1

Where the term I0 = Present value of investment outlay

1+ K

Xt

Tt
(1+i d )t
St
(1+i d )t

= Present value of operating cash flows

= Present value of interest tax shields

= Present value of interest subsidies

57
The various symbols denote,
Tt = Tax savings in year t due to financial mix adopted
St = Before-tax value of interest subsidies (on the home currency) in year t due to
project specific financing
Id = Before-tax cost of dollar debt (home currency)
Example 2: A project costing $50 million is expected to generate after-tax cash
flows bf $l million a year forever. Risk-free rate is 3%, asset beta is 1.5, required
return on market is 12%, cost of debt is 8%, annual interest costs related to project
are $2 million and tax rate is 40%. Calculate the adjusted present value of the
project.
Solution:
Adjusted Present Value = Present Value of Cash Flows + Present Value of Tax
Savings
We need to find ungeared cost of equity which is 3% + 1.5*(12% - 3%) = 16.5%.
Using this rate the present value of cash flows = $10 million/0.165 = $60.61 million.
Initial investment is $50 million no net present value of future cash flows using
ungeared cost of equity is $10.61million ($60.61 million - $50 million).
Adjusted Present value = present value of cashflows + present value of tax savings
= $10.61 million + $10million = $20.61 million
Decision Rule
The decision rule for adjusted present value is the same as net present value accept positive APV projects and reject negative APV projects. The project discussed
in the example has an APV of $20.61 which is positive hence the company should
undertake the project.

3.4.5. PROBLEMS
ASSOCIATED
INTERNATIONAL CAPITAL BUDGETING

WITH

International capital budgeting encounters a number of variables and factors that

are unique for a foreign project and are considerably more complex than their
domestic counterparts. These factors are:
1) Complexities of Regulatory Environment: The differences exist between
the parents cash flow and the projects cash flow because of tax laws and
other regulatory environment. For parent, the cash flows to the B; parent are
relevant because the shareholders expect higher rate of return. Therefore, it
is necessary to make a distinction between parents cash flow from that of
the project.

58
2) Complexities Due to Type of Financing: Parents cash flows depend on
the form of financing that parent i adopts to finance the project (debt versus
equity). Thus the parents cash flows cannot be separated from the financing
decisions.
3) Difficulty in Recognizing the Exact Remittances: Remittances to the
parent must be explicitly recognized. Because of differing tax laws, and
political systems, differences in how financial markets and institutions
function, the cash flows to the parent tend to vary. These aspects are also
required to be considered while determining parents cash flows.

Problems Associated with International Capital Budgeting

Complexities of Regulatory Environment

Complexities Due to Type of Financing
Difficulty in Recognizing the Exact Remittances
Difficulty in Anticipating Inflation Rates
Difficulty in Anticipating Changes in Exchange Rate
Segmented Capital Markets
Subsidized Loans and cost of Capital
Evaluation of Political Risk

4) Difficulty in Anticipating Inflation Rates: Differing rate of inflation must

also be anticipated for forecasting the real return and exchange rate
forecasts. Inflation also changes the competitive position of the launched
product/service. If the cash flows are in different currencies, the expected
inflation rates are required to be forecasted for evaluating a project.
5) Difficulty in Anticipating Changes in Exchange Rate: Possibility of
unanticipated changes in exchange rate changes must be considered
because of possible direct effects on the value of local cash flows as well as
on parent s cash flows. This unanticipated change will also have an indirect
effect on the competitive position of the firm, thus affecting the long run cash
flows.
6) Segmented Capital Markets: Since the project is being implemented in a
different country, therefore the capital markets are segmented by space. Use

59
of segmented capital markets may provide an opportunity or may involve
higher costs. The financing aspect has to be carefully examined.
7) Subsidized Loans and Cost of Capital: Use of subsidized loans complicate
both the capital structure and the ability to calculate weighted average cost
of capital for discounting purposes.
8) Evaluation of Political Risk: For each project political risk must be
evaluated. This is because the cash flows can be severely affected by the
changes in political environment. The changes in the government would
change the political philosophy thereby leading to new economic
environment. Extreme form of risk is the risk of expropriation. In the case of
expropriation, the projects and the parents cash flows tend to change
drastically because in this case the funds are blocked in the country of the
project.

3.5. MULTINATIONAL CORPORATION (MNC)

3.5.1. MEANING AND DEFINITION OF MNC
Multinational Corporation (MNC) or Transnational Corporation (TNC) is a corporation
or enterprise that manages production or delivers services in more than one
country.
A multinational corporation has been defined as follows:
An enterprise which allocates company resources without regards to national
frontiers, but is nationally based in terms of ownership and top management.
An enterprise which own or control production or service facilities outside the
country in which they are based.
Among the various other benchmarks sometimes it used to define multinationality
is that the company must:
1) Produce (rather than just distribute) abroad as well as in the headquarterscountry.
2) Operate in a certain minimum number of nations (six for example).
3) Derive some minimum percentage of its income from foreign operations (e.g.,
25 per cent)
4) Have a certain minimum ratio of foreign to total number of employees, or of
foreign total value of assets.
5) Possess a management team with geocentric orientations.
6) Directly control foreign investments (as opposed simply to holding shares in
foreign companies).

60

3.5.2.

FINANCIAL GOALS OF MNC

The fundamental, objective of an MNC is to earn profit and this might clash with the
host governments objective of achieving better quality of life for its citizens. Such
conflicts need to be resolved by the MNCs using their own initiative.
Following are the financial goals of MNCs and their subsidiaries:
1) Manufacture in those countries where it finds the greatest competitive
advantage.
2) Buy and sell anywhere in the world to take advantage of the most favorable
price to the company7^"
3) Take advantage, throughout the world, of changes in labor costs, productivity,
trade agreements, and currency, fluctuations.
4) Expand or contract, based on worldwide competitive advantages.
5) Obtain a high and rising return on invested capital.
6) Achieve greater sales.
7) Hold risks within reasonable limits in relation to profits.
8) Maximization of shareholders wealth.
9) Maximize the return on equity.
10)
Maintain and improve technological and other company strengths.
11)
Maintain control of important decisions.
12)
Encounter fewer barriers in host countries.

3.5.3. REASONS FOR THE GROWTH OF

MULTINATIONAL CORPORATIONS
Reasons for the growth of multinational corporations are as follows:
1) Factor Mobility: Cross border movement of factors of production like
technology, capital, labor and even management have paved the way for the
growth of MNC. International understanding and economic cooperation has
boosted the worldwide flow of factors.
2) Economic Reforms: Governments of most of the developing and
underdeveloped economies are facing problems like regressed performance
of their public sector and bureaucracy. This has led to the wastage of precious
resources resulting in poor GDP rate, which further leads to poverty and
unemployment. In order to bring back their economies on track these
governments have made several economic reforms. Globalization as a part of
such economic reforms has opened their economies to international players.
3) Opening up of Command Economies: Socialism and Communism are
giving way to capitalism.
4) Management Culture: MNCs generally adapt to local conditions and the
relationships between parent and subsidiary is that of coordinated federation.
Decisions on investment financing and market are localized. Corporate
strategic planning is essential for enhanced integration and coordination of
MNCs global activities. Whereas subsidiary level strategic planning is directed

61

5)

6)

7)
8)

towards localizing the global strategy according to the peculiarities of local

condition this autonomous adoption to fast changing Local business
Environment is the main reason for the growth of MNCs.
Growth Urge: MNCs generally have growth impetus with them. Strategic
alliances, joint ventures, wholly owned subsidiaries, mergers, acquisitions;
franchising, etc. are the diverse strategies, which MNCs adopt to exploit
global opportunities to expand their operations globally. The motives for such
expansions are:
i.
Securing supplies of minerals, energy and scarce raw materials.
ii.
Development of technology or brand recognition leading to global
demand met through overseas investment.
iii.
Availability of cheaper factors overseas, using the same by
geographically spreading their operations MNCs has technology and
competitive edge. Global spread is very simple for them unless
nations/states are purposely against the entry of MNCs. The most
essential element is the urge of MNCs to undertake and integrate
manufacturing, marketing, R&D, and finance opportunities on a global
scale rather than on domestic scale.
Market Potential: MNCs keep an eye on the international market and are
always in search of new market. The increasing market potential is great
attraction for most of the MNCs at present. MNCs like IBM, Unilever, CocaCola, Philips, etc, come in this category.
Risk Minimizing: Various agencies with their existence in the field of
reducing country risk have again dded to the cause of growth of MNCs.
Development in Communication Technology: The changing face of IT
industry has led to the fast communication around the globe. Effective
communication being the lifeline of the business management, the
technological development in the field has removed the boundaries of nation
making the whole world a Global village.

3.5.4.

MULTINATIONAL CORPORATE STRUCTURE

Multinational corporations can be divided into three broad groups according to the
configuration of their production facilities:
1) Horizontally Integrated Multinational Corporations: They manages
production establishments located in different countries to produce the same
or similar products. (For example; McDonalds)
2) Vertically Integrated Multinational Corporations: They manage
production establishment in certain country/countries to produce products
that serve as input to its production establishments in other
country/countries. (For example; Adidas or Nike, Inc.)
3) Diversified Multinational Corporations: They manage production
establishments located in different countries that are neither horizontally nor
vertically nor straight nor non-straight integrated. (For example; Microsoft or
Siemens A.G.)

62
Others argue that a key feature of the multinational is the inclusion of back
office functions in each of the countries in which they operate.

3.5.5.

FINANCIAL PERFORMANCE MEASUREMENT

Performance measurement is the key in ensuring that an organizations strategy is

successfully implemented. It is about monitoring an organizations effectiveness in
fulfilling its own pre-determined goals or stakeholder requirements. A company
must perform well in terms of cost, quality, flexibility, value, and other dimensions.
A performance measurement system that enables a company to meet these
demands successfully is essential. It helps ensure better informed and more
effective decision-making at both strategic and operational levels.
Financial performance exists at different levels of the organization. This page is
mostly concerned with measuring the financial performance of the organization as a
whole, and of measuring the performance of key projects. Further measures are
used as part of the particular problem of divisional performance appraisal.

3.5.5.1.
Mechanics of Performance
Measurement
Following steps involved in the performance measurement:
Step I: Establish Standards of Performance: Standards of performance apply
to many aspects of the organization, such as cost, quality, and customer service.
Cost standards typically incorporate more than one standard since they reflect
expected levels of manufacturing performance, such as process yields, product
quality, and overhead spending levels.
Step 2: Measure Actual Performance: The organization measures the actual
results of the process. Manual or automated data collection systems are required to
gather information about the process. In a standard cost system, the information
collected usually includes labor hours, machine hours, and materials usage. This
information is generally collected on the production floor.

63
Step 3: Analyze Performance and Compare it with' the Standards: Once the
actual
results
have
Establish
Standards
of
Performances
been
measured,
these
are
compared
against the
standard
to
identify
significant
Measure Actual Performance
deviations in
the
expected
performance.
Managers
and
their
accountants
identify
and
Analyze Performance and Compare it with Standards variances on a
analyze
regular
basis.
This
process
is
called variance
analysis.
Variances often
Construct and Implement an
signal
problems that
Action Plan
may require
investigation
and possible
action.
Review and Revise Standards
Step
4:
Construct and
Implement
an
Action
Plan: This step is a critical aspect of any management control system. In a
performance system, the variance analysis will highlight potential problem areas.
Then management must identify the source of the problem and develop plans to
correct or improve the situation. The effectiveness of a performance system
depends on managements ability to act on the information provided.
Step 5: Review and Revise Standards: Modern organizations are in a constant
state of change. This dynamic business- environment requires that standards be
updated periodically to reflect these changes. Typically standards are updated
atleast once a year during the standard-setting process. However, if the variances
are significant, the performance standards should be revised during interim periods.

3.5.5.2.
Effective Performance Measurement
System
Following are the steps which are involved in the development of an effective
performance measurement system:
1) The performance measurement system must be integrated with the overall
strategy of the business.
2) There must be a system of regular feedback and review of actual results
against the original plan and the performance measures themselves.
3) The performance measurement system must be comprehensive. It needs to
include the range of factors that contribute to the organizations success such
as competitive performance, quality of service and innovation. This requires a
range of financial and non-financial indicators.

64
4) The system must be owned and supported throughout the organization. The
implementation, must be top own so t at individuals setting strategy can
determine the objectives and develop appropriate top-level measurement
5) Measures need to be fair and achievable. Where performance measures are
used to reward managers performance, the evaluation should include only
the elements they have direct control over.
6) The system and results reporting need to be simple, clear and
understandable, particularly to non- finance professionals. There is a need to
priorities and focus so that only the key performance indicators for the
business in strategic terms are measured.

3.5.5.3.
Factors Considered in Performance
Measurement
Every control system establishes a standard of performance and compares actual
performance with the standard. The most widely used standards are budgeted
financial statements. The preparation of the statements is a planning function, but
their administration is a controlling function. Budgeted statements are prepared
without anticipated inflation or exchange rate fluctuations, but the actual
statements are prepared after these phenomena have occurred.
1) Impact of Inflation on Financial Statements: figure presents the effects of a 10
per cent and a 20 per cent rate of inflation on the major accounts of the balance
sheet and the income statement. If we assume that one unit is sold every month
and that prices increase at an even rate throughout the year, the annual inflation
rates reflected on sales would be 5 per cent and 10 per cent instead of 10 per cent
and 20 per cent.
If we follow the results of a case having a total annual inflation rate of 10 per cent,
or 0.83 per cent per month, annual sales increase to 2,100 a 5 per cent increase
over the budgeted price. The cost of goods sold increases by only 4 per cent from
the budgeted cost of 1,500 to the actual cost of 1,560, because the cost of goods
sold is based on historical costs. We assumed that interest expenses remain
constant. The budgeted depreciation charges are based on historical costs. The
combination of higher prices in sales and the use of historical costs in the two major
accounts will increase the profits after taxes by 20 per cent from 100 to 120.
The effects of inflation on the balance-sheet accounts depend on the date when
assets were acquired or liabilities incurred. Fixed assets and inventory are carried at
cost, but accounts receivable and accounts payable are carried at the prices
prevailing at the time of the transactions. The budgeted cash of 400 consists of
profits after taxes (100), taxes payable (100), and depreciation (200).
Budget

Actual
with
Inflation Rate of:

Annual
10%

65
20%
Income statement (In Foreign Currency)
Sales
Cost of goods sold
Gross margin
Depreciation
Operating income
Interest expense
Profit before taxes
Taxes (50%)
Profit after taxes

Balance Sheet (in Foreign Currency)

Cash
Accounts receivable
Inventory
Total current assets
Plant and equipment
Less: Depreciation
Total assets
Accounts payable
Notes payable
Taxes payable
Total current liabilities
Equity
Retained earnings
Total liabilities and equity

2,000
1,500
500
200
300
100
200
100
100

0
200
100
300
350
---350
300
300
---600
50
---650

2,100
1,560
540
200
340
100
240
120
120

2,200
1,620
580
200
380
100
280
140
140

Budget

Actual with Annual

Inflation Rate of:
10%
20%

400
200
100
700
350
(200)
850
300
300
100
700
50
100
850

440
220
110
770
350
(200)
920
330
300
120
750
50
120
920

480
240
120
840
350
(200)
990
360
300
140
800
40
140
990

2) Impact of Exchange Rate Fluctuation on Financial Statements: Let us

assume that a subsidiary purchases its raw materials from country A and sells its
finished products to country B. Thus, both exports and imports are denominated in
foreign currencies. In this case, exchange rate fluctuations affect the LEVel of both
revenues and costs measured in terms of the domestic currency. Table 3.2 shows
that an appreciation in the revenue currency (country Bs currency) raises profits,
assuming that costs remain constant. In contrast, an appreciation in the cost
currency (country As currency) reduces profits after taxes unless selling prices are
adjusted to reflect the increase in costs.
There are similarities between the effect of inflation and the effect of exchange rate
fluctuations on reported profits. If prices in the local currencies are increased by the

66
same percentage as the increase in the cost of imports, the effect of exchange rate
fluctuations on profits is identical with the effect of a comparable local inflation rate.
A 10 per cent increase in export prices, accompanied by a proportional increase in
import prices* produces profits of 120; this is identical to the profit obtained when
the local inflation rate was 10 per cent in the example from table 3.2.
Budget Bs
Currency As
Currency Both Currency
Appreciates
Appreciates
Appreciates
10%
10%
Sales
2,000
Cost of goods sold 1,500
Gross 500
margin
Depreciation
200
Operating 300
income
Interest expense
Profit before
tax
Taxes (50%)
Profit after
tax

2,J00
1,500
600

1,000
1,560
440

2,100
1,560
540

200
4001

200:
240

200
340

100
200

100
300

1Q0
140

100
240

100

150

70

120

150

70

100

120

We cannot determine the true impact of exchange rate fluctuations on foreign

operations unless a parents accounts and those of its subsidiaries are expressed in
terms of a homogeneous currency unit. Any changes in the value of the local
currency relative to the parent currency will affect the reported profits when
financial statements expressed in the local currency are translated into the currency
of the parent company. The translation procedure is regulated by the accounting
profession.

3.6. MULTINATIONAL CAPITAL STRUCTURE

DECISION
3.6.1. INTRODUCTION
A MNCs capital structure decision involves the choice of debt versus equity
financing within all of its subsidiaries.4'Thus, its overall capital structure is
essentially a combination of all of its subsidiaries capital structures. MNCs
recognize the trade-off between using debt and using equity for financing their
operations. The advantages of using debt as opposed to equity vary with corporate
characteristics, specific to each MNC and specific to the countries where the MNC
has established subsidiaries.

67

3.6.2. SITUATIONS DETERMINING MULTINATIONAL

FIRMS CAPITAL STRUCTURE
The MNCs operate in economies where diverse regulations exist for the mobilization
of resources by companies. These regulations may be discriminatory for MNCs.
Therefore the question of target capital structures has to be analyzed in the light of
these regulations. There may be flowing types of situations existing in various
economies which are the important determinants of capital structure of MNCs.
1) When a country does not allow the MNCs having headquarters elsewhere to
list their stock on its local stock exchange, under these conditions, MNCs
would decide to bftbw funds through debt instruments such as bonds and so
it may deviate from the target capital structure. In the process, the overall
cost of capital may rise. The dependence on debt may be reduced if the host
country allows the listing of stocks at the local stock exchange.
2) In the second situation, when the country allows the listing of stock at the
local stock exchange then in that case the nature of the project will decide
the financing pattern. If the project is not generating net cash flows for some
years, say five years or more, then the equity financing is more appropriate.
Because in the case, one can avoid net cash out flows by riot paying
dividends in the initial years of operation.
3) If a country is facing political turmoil, the use of local banks will be more
appropriate, because these banks may be able to prevent MNCs operations in
that country from being affected by the political conditions.

3.6.3. FACTORS AFFECTING MNCS CAPITAL

STRUCTURE
Following are the factors affecting MNCs capital structure:

Factors Affecting MNCs Capital Structure

Stability of MNCs Cash Flows

MNCs Credit Risk
MNCs Access to Retained Earnings
MNCs Guarantees on Debt

MNCs Agency Problems

68
1) Stability of MNCs Cash Flows: MNCs with more stable cash flows can
handle more debt because there is a constant stream of cash inflows to cover
periodic interest payments. Conversely, MNCs with erratic cash flows may
prefer less debt because they are not assured of generating enough cash in
each period to make larger interest payments on debt. MNCs that are
diversified across several countries may have more stable cash flows since
the conditions in any single country should not have a major impact on their
cash flows. Consequently, these MNCs may be able to handle a more debtintensive capital structure.
2) MNCs Credit Risk: MNCs that have lower credit risk (risk of default on loans
provided by creditors) have more access to credit. Any factors that influence
credit risk can affect a MNCs choice of using debt versus equity. For example,
if an MNCs management is thought to be strong and competent, the MNCs
credit risk may be low, allowing for easier access to debt. MNCs with assets
that serve as acceptable collateral (such as buildings, trucks and adaptable
machinery) are more able to obtain loans and may prefer to emphasize debt
financing. Conversely, MNCs with assets that are not marketable have less
acceptable collateral and may need to use a higher proportion of equity
financing.
3) MNCs Access to Retained Earnings: Highly profitable MNCs may be able
to finance most of their investment with retained earnings and therefore use
an equity-intensive capital structure. Conversely, MNCs that have small levels
of retained earnings may rely on debt financing. Growth-oriented MNCs are
less able to finance their expansion with retained earnings and tend to rely on
debt financing. MNCs with less growth need less new financing and may rely
on retained earnings (equity) rather than debt.
4) MNCs Guarantees on Debt: If the parent backs the debt of its subsidiary,
the subsidiarys borrowing capacity might be increased. Therefore, the
subsidiary might need less equity financing. At the same time, however, the
parents borrowing capacity might be reduced, as creditors will be less willing
to provide funds to the parent if those funds might be needed to rescue the
subsidiary.
5) MNCs Agency Problems: If a subsidiary in a foreign country cannot easily
be monitored by investors from the parents country, agency costs are higher.
To maximize the firms stock price, the parent may induce the subsidiary to
issue stock rather than debt in the local market so that its managers there
will be monitored. In this case, the foreign subsidiary is referred to as
partially owned rather than wholly owned by the MNCs parent. This
strategy can affect the MNCs capital structure. It may be feasible when the
MNCs parent can enhance the subsidiarys image and presence in the host
country or can motivate the subsidiarys managers by allowing them partial
ownership.

69

3.6.4. OPTIMAL FINANCIAL/CAPITAL STRUCTURE

OF MNC
The optimal financial structure of multinational firm takes into account the
following:
1) Availability of capital which may affect debt rates.
2) Can financial risk of a multinational be reduced through international
diversification?
3) What should be the financial structure of foreign subsidiary?
There is no conclusive opinion about whether an optimal financial structure exists
for a firm. There is a compromise between the Traditional School and the Modigliani
and Miller School of thought which states that, when taxes and bankruptcy costs are
considered, a firm has an optimal capital structure determined by that particular
mix of debt and equity which minimizes the firms cost of capital for a given level of
business risk. If the business risk of existing projects, the optimal mix of debt and
equity would change to recognize trade-offs between business and financial risk.
The figure 3.7 shows how the cost of capital varies with the amount of debt
employed.

Cost of Capital (%)

70

The debt ratio is

measured
along
horizontal axis and
Kd(1-)
the cost of capital
along vertical axis,
Kw
ke is the curve
describing cost of
Ke
equity, kd is the
curve
describing
behavior of cost of
Debt/ total asset
debt
and
kw
DR*
represents weighted
cost of capital. The
figure shows how
the cost of capital
varies with the amount of debt employed. As the debt ratio (total debt divided by
total assets) increases, the overall cost of capital (k) decreases because the heavier
weight of low cost dept (kd(l )) compared to high cost of equity.
The low cost of debt usually is because as debt deductibility of interest as shown by
Kd (1 -). Overall costs of capital continues to decline as debt ratio increases, until
financial risk becomes serious that investors and management perceive a real
danger of insolvency. This results in sharp increase in cost of debt. This results in Ushape. Cost of capital curve as shown by Ke. The optimal capital structure is given
by the lowest point of the marginal cost of capital curve. This point gives the
optimum debt ratio associated with the lowest cost of capital. In the figure 3.7, the
optimum debt ratio is given by DR* and the associated lowest cost of capital by K d.

3.7. INTERNATIONAL COST OF CAPITAL

3.7.1. MEANING OF COST OF CAPITAL
Cost of capital is the expected rate of return that the market requires in order to
attract funds to a particular investment. .In economic terms, the cost of capital for a
particular investment is an opportunity cost - the cost of forgoing the next best
alternative investment. In this sense, it relates to the economic principle of
substitution, i.e., an investor will not invest in a particular asset if there is a more
attractive substitute.
The market refers to the universe of investors who are reasonable candidates to
provide funds for a particular investment. Capital or funds are usually provided in
the form of cash, although in some instances capital may be provided in the form of
other assets. The cost of capital usually is expressed in percentage terms, i.e., the
annual amount of dollars that the investor requires or expects to realize, expressed
as a percentage of the dollar amount invested.

71
According to Roger Ibbotson, The opportunity cost of capital is equal to the
return that could have been earned op alternative investments at a specific level of
risk.
According to Soloman Ezra, Cost' of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure.
In other words, it is the competitive return available in the market on a comparable
investment, risk being the most important component of comparability.

3.7.2.

COST OF EQUITY

The cost of equity capital is the required rate of return needed to motivate the
investors to buy the firm's stock. Calculation of the cost of equity is a difficult
process and needs more approximations than calculating the cost of debt. For
established firms, the dividend growth model may be used for computing the cost of
equity. This model is also called Gordon model.

K e=

D1
+g
P0

Where,
Ke = Cost of equity capital
D1 = Dividends expected in year one
P0 = Current market price of the firm's stock
g = Compounded annual rate of growth in dividends or earnings
Alternatively, the cost of equity capital may be calculated by using the modern
capital market theory. According to this theory, an equilibrium relationship exists
between an asset's required rate of return and its associated risk which can be
calculated by the Capital Asset Pricing Model (CAPM).
The cost of equity may be calculated by the CAPM by using the following formula,

E( R) j =Rf + B j (E ( R )mR f )
Where,
E(R) j is the expected rate of return on asset j. R f is the rate of return on a risk free
asset measured by the current rate of return or yield on treasury bonds.
E(R)m is the expected rate of return on a broad market index such as the standard
and poor index of industrial stocks.
Bj is the beta of stock j, measured by the relative variability or volatility of the rate
of return on the stock compared to the variability of the return on a broad market

72
index. A beta of 1 (unity) denotes a risk equivalent to the one entailed in an
investment in a diversified portfolio of stocks.

3.7.3.

COST OF DEBT

The term cost of debt refers to the effective rate of interest that a company pays
on its debt. Cost of debt is the main method of cost of capital in finance and
financial management. Cost of debt is calculated on the debt, bonds, loan, or
debentures by multiplying interest rate with given amount of debt. If rate is not
given, then one can also calculate cost of debt rate. This rate is called K d. Cost of
debt is calculated by using the following formula:
Cost of debt (without any adjustment) (K d) = Amount of interest/amount of loan x
100.
In case, company issues the bonds or debenture on premium, at that time, one can
calculate cost of debt by following formula:
Cost of debt (Kd) = Interest amount/ (amount of debenture + amount of premium) x
100.
In case, company issues the bonds or debenture on discount, at that time, one can
calculate cost of debt by following formula:
Cost of debt (Kd) = Interest amount/ (amount of debenture - amount of discount) x
100
If one has to compare cost of debt with cost of equity, then he have to calculate it
after adjustment of tax because interest is deducted from profit before tax but
dividend is deducted from profit after tax.
Cost of debt = Amount of interest (1 - Tax Rate)/Amount of loan x 00
For example, interest rate of company is 10% before tax; calculate cost of debt
after tax of 30%.
Cost of debt = 10% x (1 - 30%) = 7%

3.7.4. WEIGH FED AVERAGE COST OF CAPITAL

(WACC)
A firm s weighted cost of capital is a composite of (he individual costs of financing
weighted by the percentage of financing provided by each source. Therefore, a
firm's weighted average cost of capital is a function;
1) The individual cost of capital, and
2) The make-up of the capital structure, i.e., the percentage of funds provided
by debt, preferred stock and common stock.

73
Thus, when a firm has both debt and equity in its capital structure, its financing cost
can be represented by the weighted average cost of capital. This can be computed
by weighting the after-tax borrowing cost of the firm I and the cost of equity capital
using debt ratio as the weight. Specifically
K = (1 - Wd) Ke + Wd (1 - T)i
Where,
K = Weighted average cost of capital
Ke = Cost of equity capital for a levered firm
i = Before-tax borrowing cost
T = Applicable marginal corporate tax rate
Wd = Debt to total market value ratio.

3.7.5.

COST OF CAPITAL ACROSS COUNTRIES

Just like technological or resource differences, there exist differences in the cost of
capital across countries. Such differences can be advantageous to MNCs in the
following ways:
1) Increased competitive advantage results to the MNC as a result of using low
cost capital obtained from international financial markets compared to
domestic firms in the foreign country. This, in turn, results in lower costs that
can then be translated into higher market shares.
2) MNCs have the ability to adjust international operations to capitalize on cost
of capital differences among countries, something not possible for domestic
firms. Country differences in the use of debt or equity can be understood and
capitalized oh by MNCs.

3.7.5.1.

Country Differences in Cost of Debt

Before tax cost of debt (Kd) = Rf + Risk Premium

This is the prevailing risk free interest rate in the currency borrowed and the risk
premium, required by creditors. Thus the cost of debt in two countries may differ
due to difference in the risk free rate or the risk premium.
1) Differences in Risk Free Rate: Since the risk free rate is a function of
supply and demand, any factors affecting the supply and demand will affect
the risk free rate, these factors include:
i).
Tax Laws: Incentives to save may influence the supply of savings and
thus the interest rates, the corporate tax laws may also affect interest
rates through effects on "corporate demand for funds.
ii).
Demographics: They affect the supply of savings available and the
amount of loanable fends demanded depending on the culture and

74
values of a given country. This may affect the interest rates in
country.
iii).
Monetary Policy: It affects interest rates through the supply of
loanable funds. Thus a loose monetary policy results in lower interest
rates of a low rate of inflation is maintained in the country.
iv).
Economic Conditions: A high expected rate of inflation results in the
creditors expecting a high rate of interest which increases the risk free
rate.
2) Differences in Risk Premium: The risk premium on the debt must be large
enough ^compensate the creditors for the risk of default by the borrowers.
The risk varies with the following:
i).
Economic Conditions: Stable economic conditions result in a low risk
of recession. Thus there is a lower probability of default.
ii).
Relationships between Creditors and Corporations: If the
relationships are close and the creditors would support the firm in case
of financial distress, the risk of illiquidity of the firm is very low. Thus a
lower risk premium.
iii).
Government Intervention: If the government is willing to intervene
and rescue a-firm, the risk of bankruptcy and thus, default is very low,
resulting in a low risk premium.
iv).
Degree of Financial Leverage: All other factors being the same,
highly leveraged firms would have to pay a higher risk premium.

3.7.5.2.

Country Differences in Cost of Equity

Cost of equity (Ke) = Rf + (Rm- Rf)b

The return on equity can be measured as an interest free rate that could have been
earned by the shareholders, plus a premium to reflect the risk of the firm. Since risk
free interest rates vary if we describe how finance managers generally pay little
attention to what the theory says they should do about their capital structure and
across countries, the costs of equity can also vary.
In a country with many investment Opportunities, potential returns may be
relatively high, resulting in a high cost of funds and thus a high cost of capital. Issue
and floatation costs, the dividends given to the shareholders, withholding taxes and
capital gains taxes are some of the variants that affect the cost of equity of the
MNCs cost of equity.

3.7.5.3.
Firms

Cost of Capital for MNCs Vs Domestic

The cost of capital for an MNC may differ from that of a fully established domestic
firm on account of the characteristics of MNCs that differentiate them from domestic
firms. These differences include the following:

75
1) Size of the Firm: Firms that operate internationally are usually much bigger
in size than firms which operate only in the domestic market. Firms that
operate internationally generally borrow substantial amounts of funds and by
virtue of their size, they are generally ail a position to reduce the various
transaction and brokerage costs and also get preferential treatment from
creditors. This helps them to reduce their cost of capital compared to
domestic firms.
2) Foreign Exchange Risk: An exceptionally volatile exchange rate, or one
that always depreciates, is riot conducive to attracting long-term foreign
investors. Such a MNCs cash flow would have wide fluctuations and the
capability of the corporation to make various fixed term commitments like
interest would get reduced. This may force the shareholders and creditors to
demand a higher return which, in turn, increases the MNCs cost of capital. A
firm more exposed to exchange rate fluctuations would have a wider spread
of possible Cash flows in future periods. Thus, exposure to exchange rate
fluctuations could lead to a higher cost of capital.
3) Access to International Capital Markets: The fact that MNCs can normally
access the international capital market helps them to attract funds at a lower
cost than the domestic firms. In a global context, since the funds are not
completely mobile, the cost of funds varies among markets. Also, the
subsidiary can obtain local funds at a lower rate than the parent if the
prevailing interest rates in the host country are relatively low. This form of
financing helps to lower the cost of capital and will generally not increase the
MNCs exposure to exchange rate risk.
4) International Diversification Effect: If a firm's cash inflows come from
sources all over the world, there might be more stability in them. MNCs like
Nike, Coca-Cola, Microsoft, Intel, Procter and Gamble, British Airways, etc.,
have cash inflows coming from sources all over the world.
5) Political Risk: Political risk can be accounted for in the cost of capital
calculations by adding an arbitrary risk premium to the domestic cost of
capital for a project of comparable risk. As political risk is likely to be higher in
the later years of a project, cash flows in later years tend to get reduced.
Thus, political risk impacts the cost of capital of the MNC by moving it
upwards as compared to a domestic firm.
6) Country Risk: Country risk represents the potentially adverse impact of a
country's environment on the MNCs cash flows. If the country risk level of a
particular country begins .to increase, the MNC may consider divesting its
subsidiaries located .there. Several risk characteristics of a country may
significantly affect the cash flows of the MNC and the MNC should be
concerned about the degree of impact likely for each.
If the country risk is high and it has invested a high percentage of its assets
in such a country, then its probability of bankruptcy is higher. In a situation of
high country risk, the cost of capital will also tend to be high.
7) Tax Concessions: MNCs generally choose countries where the tax laws are
favorable for them as their net income is substantially influenced by the tax

76
laws in the locations where they operate. In some cases, the MNC may be
able to lower its cost of capital by availing of the various tax advantages not
available to a purely domestic firm,

3.8. INTERNATIONAL CASH MANAGEMENT

3.8.1. MEANING OF CASH MANAGEMENT
Cash management means optimization of cash flows and the investment of excess
cash. Since firms operate in multinational financial environment, therefore cash
management is very complex, because of different legal environment prevailing in
various countries in respect of cross border cash transfers. In addition, the exchange
the fluctuations affect the values of these cross border transfers.

3.8.2. OBJECTIVES OF INTERNATIONAL CASH

MANAGEMENT
1) The basic objectives of an effective international cash management system
are:
2) Minimize the currency exposure risk.
3) Minimize the country and political risk.
4) Minimize the overall cash requirements of the company as a whole without
disturbing the smooth operations of the subsidiary or its affiliate.
5) Minimize the transactions costs.
6) Full benefits of economies of scale as well as the benefit of superior
knowledge.

3.8.3.

CASH FLOWS OF A SUBSIDIARY

Management of cash is interwoven with the management of working capital. The

subsidiaries in a country not only use local resources, but these also use imports.
Therefore, the subsidiary faces a difficult time to forecast future outflows especially
when the exchange rate is volatile. Sometimes the subsidiaries expect invoice
currency of the supplies to appreciate and desires to build an inventory of imported
supplies so that it can draw on inventories to lower the cost of production or it
required time to search for an alternative.
The major outflows from a subsidiary are in the following forms:
1)
2)
3)
4)
5)

Fees, royalties and dividend (outflow to the parent in foreign exchange).

Loan repayment (local and foreign).
Accounts payable (local and foreign),
Raw material supplies cash purchases (local and foreign).
Investments (local and foreign).

These outflows are difficult to forecast because of the following reasons:

77
1) The exchange rate fluctuations change the value of these outflows,
2) The import restrictions may be imposed by the host country, which may
change the value of raw material imports, and
3) Future sales of the subsidiary are uncertain, therefore the outflows are
uncertain. The sale volumes of internationally traded goods are more volatile.
The inflows of a subsidiary are:
1)
2)
3)
4)
5)

Cash sales (local and foreign currency)

Accounts receivables (local and foreign currency).
Interest earning on investments.
Loan from other sources other than parent (local and foreign).
Loans from the parent (foreign currency).

The cash flow of a subsidiary is shown in below Figure

The inflows are also uncertain because a part of inflows of a subsidiary are
denominated in foreign exchange. The change in exchange rate, changes the values
of these inflows. Other major cause of the change in inflows the change in sale
volume. Cash sales and accounts receivable depend on the volume cash and credit
sales. Sale volume also depend on the credit standard of a company. If credit
standard are lowered, the sales are likely to increase.

78

Payments
Payments

Cash Flows

Production

Cash Flows of a Subsidiary

After accounting for inflows and outflows, the subsidiary would find itself with either
excess cash or deficient cash. Thus it will need either to invest or to borrow cash

79
periodically. If it expects deficiency of cash, then short term financing is needed.
The cost of short term domestic financing has to be compared with foreign
financing. If the cash is in excess, it has to be invested. Investment market has to
be determined. Foreign exchange fluctuations make the return uncertain.

3.8.4.

CENTRALIZED CASH FLOW MANAGEMENT

The subsidiaries are more concerned with their own operations rather than the
overall performance of the MNC. To maximize the value of the MNC, a value adding
cash management system is to be evolved. To reach this objective, a centralized
cash management group may need to monitor and manage the parent subsidiary
and inter-subsidiary cash flows. This system will be helpful to the company as a
whole and to subsidiaries individually because it will be able to help subsidiaries
which are over exposed to exchange risk. Below figure shows the overall cash flows
of an MNC with two subsidiaries:

Funds Surplus

Funds Surplus

80

Cash
Excess
Excess
Returns

Cash

Repayments interest,
principle
Long
term investment
Free royalties and earnings
Loans and investment

Loans
Funds from new stocks
Cash dividend Purchase of securities

Interest, principle on account of excess cash

Sales of Securities

Fees, royalties and earnings

Loans debt. Inv.

81

3.8.4.1.
Centralized versus Decentralized Cash
Management
Excess
cash parts of the world has cash
A multinational corporation with subsidiaries
in different
flows in a variety of currencies and countries. It can leave cash management to
individual subsidiaries (who will also manage their currency exposures) or have acentralized cash management system. In the latter case it can create a Cash
Management Centre which may be a part of the parent company, located at one
of the subsidiaries or a separate entity incorporated for that purpose. Centralized
cash management has several advantages which are discussed below:

3.8.4.2.

Location of the Centralized Pool

The centralized pool may be located either in the host country or in the home
country or in a third country. The LOCATION
depends
upon the
factors:
Interest,
principle
on following
account of
Strength of the Currency of that Country: This means that the currency must
be strong.
1) Strength of the Money Market: The stronger and well developed the
money market, the greater will be the investment avenues.
2) Tax Rate: Tax rate should be the lowest. In fact, this is the reason that most
of the US multinationals locates their centralized cash pool in tax-haven
countries, such as Panama, Cayman Islands, and the Bahamas.
3) Political Stability: The greater the political stability, the easier and safer it
will be to locate the centralized pool of cash.
4) Attitude of the Host Government: Pool is located only in those countries
where the attitude of the government is congenial towards foreign
companies.

3.8.4.3.
Advantages of Centralized Cash
Management
Following are the advantages of centralized cash management:
1) Netting: In a typical multinational family of companies, there are a large
number of intra-corporate transactions between subsidiaries and the parent.
If all the resulting cash flows are executed on a bilateral, pair-wise basis, a
large number of currency conversions would be involved with substantial
transaction costs. With a centralized system, netting is possible whereby the
Cash Management Centre (CMC) nets out receivables against payables, and
only the net cash flows are settled among different units of the corporate
family.
2) Exposure Management: If individual subsidiaries are left to manage their
currency exposures, each will have to access the forward market (or other
appropriate hedging devices), once again increasing transactions costs. The
CMC can adopt a corporate perspective and look at the overall currency

82
composition of receivables and payables. Since the overall portfolio will be
fairly diversified, currency risk is considerably reduced. The CMC can match
and pair receivables and payables and exploit the close correlations between
some currencies e.g., EUR and GBP to achieve some degree of natural
hedge.
3) Cash Pooling: The CMC can act not only as a netting center but also the
repository of all surplus funds. y Under this system, all units are asked to
transfer their surplus cash to the CMC, which transfers them among the units
as needed and undertakes investment of surplus funds and short-term
borrowing on behalf of the entire corporate family. The CMC can, in fact,
function as a finance company which accepts loans from individual surplus
units, makes loans to deficit units and also undertakes market borrowing and
investment. By denominating the intra-corporate loans in the units
currencies, the responsibility for exposure management is entirely transferred
to the finance company and the operating subsidiaries can concentrate on
their main business, viz., production and selling of goods and services. Cash
pooling will also reduce overall cash needs since cash requirements of
individual units will not be synchronous,

3.8.4.4.
Disadvantages of Centralized Cash
Management
Following are the disadvantages of centralized cash management:
1) Despite these advantages, complete centralization of cash management and
funds holding will generally not be possible. Some funds have to be held
locally in each subsidiary to meet unforeseen payments since banking
systems in many developing countries do not permit rapid transfers of funds.
2) Also, some local problems in dealing with customers, suppliers and so on,
have to be handled on the spot for which purpose local banks have to be
used and local banking relationships are essential.
3) Each corporation must evolve its own optimal degree of centralization
depending upon the nature of its global operations, locations of its
subsidiaries and so forth.
4) Further, conflicts of interest can .arise if a subsidiary is not wholly owned but
a joint venture with a minority local stake. What is optimal with regard to
cash and exposure management from an overall corporate perspective need
not be necessarily so from the point of view of local shareholders.

3.9.1.

3.9. PROJECT FINANCE

MEANING OF PROJECT FINANCE

Project financing may be defined as the raising of funds required to finance an

economically separable capital investment proposal in which the lenders mainly rely
on the estimated cashflow from the project to service their loans.

Subsidiary
A

Subsidiary
B

83
The term project finance is generally used to refer to a non-recourse or limited
recourse financing structure in which debt, equity, and credit enhancement are
combined for the construction and operation, or the refinancing, of ,a particular
facility in a capital-intensive industry, in which lenders base credit appraisals on the
projected revenues from the operation of the facility, rather than the general assets
or the credit of the sponsor of the facility, and rely on the assets of the facility,
including any revenue-producing contracts and other cashflow generated by the
facility, s collateral for the debt.
In a project financing, therefore, the debt terms are not based on the sponsors
credit support or on the value of the physical assets of the project. Rather, project
performance, both technical and economic, is the nucleus of project finance.

3.9.2.

SOURCES OF PROJECT FINANCE

Following are the different sources of project finance:

1) Shareholders: These are public or private investors, institutions, or
individuals who provide the equity or quasi-equity in a company. Sources of
equity includes the following:
i).
Retained profit of a company,
Funds raised through the stock market,
ii).
Venture capital companies,
iii).
Joint venture partners, and
iv).
International investment institutions such as the World Bank.
2) Banks: Banks and other financial institutions are the main providers of debt.
Commercial banks are the most readily available to most project investors.
They split into retail banks, which provide finance in the local, main-street
and merchant banks. There is a large choice available for companies raising
finance, and this has led to intense competition. In*choosing a bank, thedecision will not be so much based on the interest rate charged as on the
following factors:
i).
The size of the bank,
ii).
The experience in financing that type of project, and
iii).
Any support they may offer with the financial engineering.
3) International Financial Markets: International financial markets offer an
alternative to domestic markets, giving easy access to foreign sources of
funds. There are many, but the two most important are the Eurocurrency and
Eurobond markets. TheiEurocrrency and Eurobond markets are the most
efficient in the world and provide for smooth movement of funds. They
provide short-term finance at competitive rates but are primarily for large
organizations.
4) Institutions: The institutions, i.e., pension funds, insurance funds and trust
funds, generally require a fixed, steady income stream and a low level of risk
when making an investment or lending money. They will generally consider
construction developments only on prime sites with few planning problems,

84
preferably a freehold pre-let scheme, using an established developer. They
usually look for large schemes in which to invest. However, the institutions
are becoming more flexible and may consider short-term finance. They have
also become more prepared to undertake their own developments.
5) Finance for Overseas Projects: A number of additional sources of finance
are open to overseas project, in particular.
6) National or International Development Banks: National development
organizations and regional or international agencies sometimes offer longterm loans for certain classes of projects at low rates of interest. Each
organization or agency has its own pending criteria and the eligibility of a
specific project will depend on its size, purpose and sponsor
Development banks tend to take a long time to evaluate a project and are
likely to impose conditions such as putting-out all construction and
equipment contracts to competitive tender. However, they can be helpful in
attracting other sources of finance once the project has been approved and
will finance supporting infrastructure.
7) Export Credit Finance: Export credit finance should be considered where a
project requires capital goods and associated services to be imported
because:
i.
The term of the loan can sometimes be longer than the term for
commercial funds.
ii.
The rate of interest is often subsidized and fixed for the life of the loan.
iii.
The loan is very often available in both local and foreign currency.
iv.
The buyer credit itself will provide for a loan up to 85% of the cost of
eligible goods.

3.9.3.

INSTRUMENTS OF PROJECT FINANCING

The following are the main instruments/means of project finance:

Instruments of Project Financing

Equity Shares

Preference Shares

Term Loan

Internal Accruals

Methods of Offering

Venture Capital
Private Equity

85
1) Equity Shares: Equity shares are, earlier, known as ordinary shares or
common shares. Equity shareholders are the real owners of the company as
they have the Voting rights and enjoy decision-making authority on important
matters, related to the company. The shareholders return is in the form of
dividend, which is dependent on the profits of *the company and capital
gain/loss, at the time of their sale. They enjoy higher returns if the company
performs well and may not get any dividend, at all, if the company does not
do well or when the Board of Directors do not recommend any dividend for
payment. Therefore, equity shares are known as variable income security.
They are the last one to get repayment in the event of liquidation of the
company.
2) Preference Shares: Preference capital represents a hybrid form of financing
- it par takes some characteristics of equity and some attributes of
debentures. It resembles equity in the following ways:
i).
Preference dividend is payable only out of distributable profits;
ii).
Preference dividend is not an obligatory payment (the payment of
preference dividend is entirely within the discretion of directors); and
iii).
Preference dividend is not a tax-deductible payment.
Preference capital is similar to debentures in several ways:
i).
ii).

The dividend rate on preference capital is usually fixed;

The claim of preference shareholders is prior to the claim of equity
shareholders; arid
iii).
Preference shareholders do not normally enjoy the right to vote.
3) Term Loan: Term loans, also referred to as term finance; represent a source
of debt finance which is generally repayable in more than one year but less
than 10 years. They are employed to finance acquisition of fixed assets and
working capital margin. Term loans differ from short-term bank loans which
are employed to finance short-term working capital need and tend to be selfliquidating over a period of time, usually less than one year.
4) Internal Accruals: Internal accruals form part of the means-of-finance in
respect of expansion projects. As existing company that goes for an
expansion (or diversification or modernization) project may opt to finance a
portion of the capital investment out of internal cash accruals. Depreciation
which is not cash expenditure and profits retained after payment of dividends
are the main sources of internally generated funds. Apart from the internal
funds that have already been generated, the likely internal generation during
the course of project implementation can also be used as a source for funding
expansion projects.
5) Methods of Offering: There are different ways in which a company may
raise finances in the primary market:
i).
Public Issue: By far the most important method of issuing securities,
a public issue, involves sale of securities to the public at large. Public
issues in India are governed by the provisions of the Companies Act,

86
1956, SEBI Guidelines on Investor Protection, and the listing agreement
between the issuing company and the stock exchanges.
The Companies Act describes the procedure to be followed in offering
shares to the public and the type of information to be disclosed in the
prospectus and the SEBI guidelines impose certain conditions on the
issuers besides specifying the additional information to be disclosed to
the investors.
ii).
Rights Issue: A rights issue involves selling securities in the primary
market by issuing rights to the existing shareholders. When a company
issues additional equity capital, it has to be offered in the first instance
to the existing shareholders on a pro rata basis. This is required under
Section 81 of the Companies Act 1956. The shareholders, however,
may by a special resolution forfeit this right, partially or fully, to enable
a company to issue additional capital to the public.
iii).
Private Placement: Private placement and preferential allotment
involve sale of securities to a limited number of sophisticated investors
such as financial institutions, mutual funds, venture capital funds,
banks, and so on.
In a preferential allotment, the identity of investors is known when the
issuing company seeks the approval of its shareholders, whereas in a
private placement, the identity of investors is not known when the
offer document (popularly known as the information memorandum) is
prepared.
In the Indian context we find that broadly, private placement refers to
sale of equity or equity related instruments of an unlisted company or
sale of debentures of de listed or unlisted company.
6) Venture Capital: Venture capital refers to an equity/equity-related
investment in a growth-oriented small/medium business to enable the
investors to accomplish corporate objectives, in return for monetary
shareholding in the business or the irrevocable right to acquire it. Venture
capital is a typical private equity investment.
According to 1995 Finance Bill, Venture capital is defined as long-term
equity investment in novel technology based projects with display potential
for significant growth and financial return.
7) Private Equity: Equity capital that is not quoted on a public exchange is
called private equity. Private equity consists of investors and funds that make
investments directly into private companies or conduct buyouts of public
companies that result in a delisting of public equity. Capital for private equity
is raised from retail and institutional investors, and can be used to fund new
technologies, expand working capital within an owned company, make
acquisitions, or to strengthen a balance sheet.
According to Gompers and Learner, Private equity is defined as dedicated
pools of capital which are managed by independent PE firms and focus on
equity or equity-linked investments in privately held companies.

87

3.9.4.

ADVANTAGES OF PROJECT FINANCING

There are a variety of reasons for the investors to make use of project finance:
1) High Leverage: One major reason for using project finance is that
investments in ventures such as power generation or road building have to
be long-term but do not offer an inherently high return; high leverage
improves the return for an investor.
2) Tax Benefits: A further factor that may make high leverage more attractive
is that interest is tax deductible, whereas dividends to shareholders are not,
which makes debt even cheaper than equity and hence encourages high
leverage.
3) Off-Balance Sheet Financing: If the investor has to raise the debt and then
inject it into the project, this will clearly appear on the investors balance
sheet. A project finance structure may allow the investor to keep the debt-off
the consolidated balance sheet, but usually only if the investor is a minority
shareholder the project which may be achieved if the project is owned
through a joint venture. Keeping debt-off the balance sheet is sometimes
seen as beneficial to a companys position in the financial markets, but a
companys shareholders and lenders should normally take account of risks
involved in any off-balance sheet activities, which are generally revealed in
notes to the published accounts even if they are not included in the balance
sheet figures; so although joint ventures often raise project finance for other
reasons, project finance should not usually be undertaken purely to keep
debt-off the investors balance sheets.
4) Borrowing Capacity: Project finance increases the level of debt that can be
borrowed against a project; non-recourse finance raised by the project
company is not normally counted against corporate credit lines (therefore in
this sense it may be off-balance sheet). It may thus increase an investors
overall borrowing capacity, and hence, the ability to undertake several major
projects simultaneously.
5) Risk Limitation: An investor in a project raising funds through project
finance does not normally guarantee the repayment of the debt the risk is
therefore limited to the amount of the equity investment. A companys credit
rating is also less likely to be downgraded if its risks on project investments
are limited through a project finance structure.
6) Risk Spreading/Joint Ventures: A project may be too large for one investor
to undertake, so others may be brought-in to share the risk in a joint venture
project company. This both enables the risk to be spread between investors
and limits the amount of each investors risk because of the non-recourse
nature of the project companys debt financing.
7) Long-Term Finance: Project finance loans typically have a longer-term than
corporate finance. Long-term financing is necessary if the assets financed
normally have a high capital cost that cannot be recovered over a short-term
without pushing-up the cost that must be charged for the projects end-

88
product. So, loans for power projects often run for nearly 20 years, and for
infrastructure projects even longer.
8) Enhanced Credit: If the off-taker has a better credit standing than the
equity investor, this may enable debt to be raised for the project on better
terms than the investor would be able to obtain from a corporate loan.
9) Unequal Partnerships: Projects are often put together by a developer with
an idea but little money, who then has to find investors. A project finance
structure, which requires less equity, makes it easier for the weak developer
to maintain an equal partnership, because if the absolute level of the equity
in the project is low, the required investment from the weak partner is also
low.

3.9.5.

DISADVANTAGES OF PROJECT FINANCING

Project financing will not necessarily lead to a lower cost of capital in all
circumstances. Project financings are costly to arrange, and these costs may
outweigh the advantages explained above.
1) Complexity of Project Financings: Project financing is structured around a
set of contracts that must be negotiated by all the parties to a project. They
can be quite complex and therefore costly to arrange. They normally take
more time to arrange than a conventional financing. Project financings
typically also require a greater investment of managements time than a
conventional financing.
2) Indirect Credit Support: For any particular (ultimate) obligor of the
projects debt and any given degree of leverage in the capital structure, the
cost of debt is typically higher in a project financing than in a comparable
conventional financing because of the indirect nature of the credit support.
The credit support for a project financing is provided through contractual
commitments rather than through a direct promise to pay. Lenders to a
project will naturally be concerned that the contractual commitments might
somehow fail to provide an uninterrupted flow of debt service in some
unforeseen contingency. As a result, they typically require a yield premium to
compensate for this risk.
3) Higher Transaction Costs: Because of their greater complexity, project
financings involve higher transaction costs than comparable conventional
financings. These higher transaction costs reflect the legal expense involved
in designing the project structure, researching and dealing with projectrelated tax and legal issues, and preparing the necessary project ownership,
loan documentation and other contracts.

decisions in Olobal Markets (Unit 3)