International Finance

BBA – 8 1

TOPIC – 9
FOREIGN DIRECT INVESTMENT (FDI)

FOREIGN DIRECT INVESTMENT

Foreign direct investment (FDI) is an investment made by a firm or individual in one country into
business interests located in another country. Generally, FDI takes place when an investor
establishes foreign business operations or acquires foreign business assets, including
establishing ownership or controlling interest in a foreign company. Foreign direct investments are
distinguished from portfolio investments in which an investor mere/ly purchases equities of
foreign-based companies.

DEFINITION
It is a process whereby residents of one country acquire ownership of assets for the purpose of
controlling the production and distribution and other activities.

ADVANTAGES AND DISADVANTAGES OF FOREIGN DIRECT INVESTMENT

Advantages

1. Easy access to the international market

Many countries still have several import tariffs in place, so reaching these countries through
international trade is difficult. There are certain industries that require being present in international
markets in order to succeed, and they are the ones who then provide FDI to industries in such
countries, so that they can increase their sales presence there.

2. Tax incentives
Many parent enterprises provide FDI because of the tax incentives that they get. Governments of
certain countries invite FDI because they get additional expertise, technology, and products. So, to
avail these benefits, they provide great tax incentives for foreign investors, which ultimately suit all
parties.

3. Helpful for the management of cost control

Foreign investment reduces the disparity that exists between costs and revenues, especially when
they are calculated in different currencies. By controlling an enterprise in a foreign country, a
company is ensuring that the costs of production are incurred in the same market where the goods
will ultimately be sold.

4. Fulfill the need of the country

Different international markets have different tastes, preferences, requirements. By investing in a
company in such a country, an enterprise ensures that its business practices and products match the
needs of the market in that country specifically.

5. Provide locally produced goods

Some markets prefer locally produced goods due to a strong sense of patriotism and nationalism.
FDI helps enterprises enter such markets and provide those goods which are needed in the market.

6. Strengthen the political relationship

FDI is beneficial, because they provide advanced resources and additional capital at minimum cost.
So they always welcome, and it also helps strengthen the political relationships between various
nations.

By: Jamshaid Iftikhar

International Finance
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Disadvantages

1. Risky political situation

Foreign investments are always risky because the political situation in some countries can change
in an instant. The investor could suddenly find his investment in serious danger due to several
different reasons, so the risk factor is always extremely high.

2. Government control
Sometimes a scenario developed where the government takes control of a firm's property and
assets, if it feels that the enterprise is a threat to national security.

3. Cultural differences
Many times, the cultural differences between different countries create major differences in the
philosophy of both the parties lead to several disagreements, and ultimately a failed business
venture. So, it is necessary for both the parties to understand each other and compromise on certain
principles. This point is directly related to globalization as well.

4. More investment required

Investing in foreign countries is infinitely more expensive than exporting goods. So an investor
should be prepared to spend a lot of money for the purpose of setting up a good base of operations.
This is something that parent enterprises know and are well prepared for, in most cases.

5. Unreal expectations
FDI is losing their national identity. They have to deal with interference from a group of people
who do not understand the history of the country and many other aspects. They have unreal
expectations placed on them, and they have to handle several cultural clashes at the same time.

TYPES OF FOREIGN DIRECT INVESTMENT

1. Horizontal FDI
It is the investment done by a company or organization which practices all the tasks and activities
done at the investing company. Therefore the investors are from the same industry where
investments are done, but operating in two different countries. For e.g., a car manufacture in
Australia invests in a car manufacturing company of Pakistan.

2. Vertical FDI
The Vertical FDI is the combination and expansion of a firm into a stage of the production process
other than that of the original business.

In other words when a company expands its operations to control more of the manufacturing or
distribution of its product by either acquiring another company or building out existing segments.

Vertical FDI are the following types.

a. Forward integration
Forward vertical integration in business is when a manufacturer decides to perform distribution
and/or retail functions within the distribution channel. This is commonly referred to as "eliminating
the middle man," as manufacturers may cut out the wholesaler to sell directly to retailers or the
retailer to sell directly to customers.

b. Backward integration

By: Jamshaid Iftikhar

International Finance
BBA – 8 3
In such investments, foreign investments are done in an organization which is involved in sourcing
of products for the particular industry. For e.g., the car manufacturer of Japan invests in a tyre
manufacturing plant in Pakistan.

c. Conglomerate FDI
A conglomerate merger is a merger between firms that are involved in totally unrelated business
activities.

A conglomerate has a large number of diversified businesses. Tata Group is one of the world's most
diversified businesses and a great example of a conglomerate. Another is Samsung – the electronics
giant also makes military hardware, apartments, ships and electronics.

3. Greenfield Entry
A green field investment is a type of foreign direct investment (FDI) where a parent company
builds its operations in a foreign country from the ground up. In addition to the construction of new
production facilities, these projects can also include the building of new distribution hubs, offices
and living quarters.

A Greenfield investment is the type of venture where finances are employed to create a new
physical facility for a business in a location where no existing facilities are currently present. A
Greenfield investment originally referred to locating new company buildings

4. Foreign Takeover
This type of FDI takes the form of a foreign merger, acquisition or takeover of an existing foreign
company. There are several types of takeovers: -

a. Friendly takeovers
A friendly takeover occurs when the target company is happy about the arrangement. In other
words, its directors and shareholders have approved the offer.

b. A hostile takeover
In a hostile takeover situation, the target company does not want the bidder to acquire it. This can
only happen where the directors are not typically majority shareholders.

c. A reverse takeover
A reverse takeover occurs when a private company purchases a publicly-listed company.

d. Back flip takeovers

This occurs when the acquiring company becomes a subsidiary of the company it purchases.

By: Jamshaid Iftikhar