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Chapter 16

Foreign Direct Investment


and International Capital Budgeting

Objectives
To discuss the characteristics of FDI
To outline the theories of FDI
To describe the techniques of international capital
budgeting
To examine the implications of taxation, country risk
and transfer prices for international capital budgeting

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Definition
An investment project is classified as direct
investment if the investor acquires significant
control over a firm

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What is significant control?


Ownership of 10-25%
United States, Japan and Australia: 10%
France, Germany and United Kingdom: higher
threshold
Belgium and the Netherlands: no specific number

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Reasons for interest in FDI


Rapid growth and changing pattern of FDI
Concern about causes and consequences of foreign
ownership
FDI channels resources to developing countries
The role played in transforming ex-communist
countries

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Modes of foreign market entry

Export of the goods produced in the source country


Licensing a foreign company to use technology
Foreign distribution of products through a subsidiary
Foreign (international) production

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Choice between exporting and FDI

Profitability
Opportunities for market growth
Production cost levels
Economies of scale

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Licensing
This involves the supply of technology and knowhow or the use of a trademark or a patent for a fee
It offers one way to generate revenue from foreign
markets that are otherwise inaccessible

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

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Types of FDI

Greenfield investment
Brownfield investment
Mergers and acquisitions
Joint ventures

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Choice between greenfield investment and


M&As
Firms with lower R&D intensity, more diversified
firms and large multinationals are more inclined to
indulge in M&As
Inter-country cultural and economic differences
reduce the tendency for M&As

(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd
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Choice between greenfield investment and


M&As (cont.)
Multinationals with subsidiaries prefer acquisitions.
The tendency for M&As depends on the supply of
target firms
Slow growth in an industry encourages M&As

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

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The differential rates of return hypothesis


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

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The diversification hypothesis


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

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The output and market size hypothesis


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

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The industrial organisation hypothesis


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

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The internalisation hypothesis


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

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The location hypothesis


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

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The eclectic theory


Three conditions must be satisfied if a firm is to
engage in FDI:
(i) It must have comparative advantages
(ii) It is better to use rather than lease these advantages
(iii) It is more profitable to use these advantages with
factor inputs abroad

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The product life cycle hypothesis


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

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The oligopolistic reaction hypothesis


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

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The internal financing hypothesis


FDI is determined by the foreign subsidiaries
internally generated funds

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The currency areas hypothesis


Countries with strong currencies tend to be sources
of FDI
Countries with weak currencies tend to be recipients
of FDI

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Diversification with barriers to capital flows


FDI arises from the desire to diversify through two
conditions:
(i) Barriers or costs to portfolio flows
(ii) Multinationals provide diversification opportunities

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Political stability and risk


Lack of political stability discourages FDI inflows
Political risk arises because of unexpected
modifications of the legal and fiscal framework in the
host country

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Tax policies
Tax policies affect incentives to engage in FDI
because:
tax treatment of income generated abroad affects the
rate of return
tax treatment of income generated at home affects
relative profitability
tax policies affect the relative cost of capital

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Government regulations
Regulations may provide incentives
(such as tax credits and exemptions)
Regulations may provide disincentives
(such as slow processing of required authorisation)

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Strategic and long-term factors


The desire to defend foreign markets against
competitors
The desire to gain and maintain a foothold in a
protected market
The need to develop a parent-subsidiary relationship

(cont.)
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Strategic and long-term factors (cont.)


The desire to induce the host country into a longterm commitment to a particular type of technology
The advantage of complementing another type of
investment
The economies of new product development
Competition for market shares among oligopolists

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Evaluating direct investment projects

Accounting rate of return


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

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Accounting rate of return


This is the percentage return on capital
The method is criticised because:
it is based on profit rather than cash flows
it ignores the size of the project and the time value of
money

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Payback period
The payback period measures how quickly the cost
is recovered
It is based on cash flows
It ignores the time value of money and the cash
flows arising after the payback period

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Net present value


Ct
t
t 1 (1 r )
n

NPV C0

E E D D
r
r
r
E D
E D

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Internal rate of return

Ct
C0
0
t
t 1 (1 r )
n

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Adjusting project assessment for risk


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

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Evaluating FDI projects


Two problems:
(i) Measurement of cash flows
(ii) Choice of discount rate

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Problems of cash flow measurement


Cash flows accruing to the parent company and the
subsidiary are different because of:

different tax rates


restrictions on remittances
excessive remittances
changes in exchange rates

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Forecasting cash flows

Demand for the product


Price of the product
Variable costs
Fixed costs
Project lifetime

(cont.)
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Forecasting cash flows (cont.)

Salvage value
Remittance restrictions
Tax rates and laws
Exchange rates

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The evaluation process


Estimating incremental cash flows
Estimating remittable cash flows in domestic
currency
Incorporating indirect costs and benefits
Discounting cash flows

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The cost of capital


This is the minimum risk-adjusted rate of return
required in order for the investment to be accepted
It is used as a discount rate for future cash flows

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The cost of capital for multinationals


This is likely to be different from that of domestic
firms because multinationals:

receive preferential treatment


have better access to international capital markets
are more diversified
have volatile cash flows

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The APV technique


The following items are taken into account:

Remittable cash flows


Tax savings and subsidies
Effect on corporate debt capacity
Other cash flows

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International taxation
This is the taxation of cross-border transactions
Double taxation arises if income earned abroad is
taxed at home and abroad

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Approaches to international taxation


Classic approach: income received by each taxable
entity is taxed
Integrated approach: aims at eliminating double
taxation by:
taxing undistributed earnings at a higher rate
imputation tax system

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Types of taxes

Corporate income tax


Withholding taxes
Indirect taxes
Import duties
Taxes on FX gains

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Avoiding double taxation


Many countries have bilateral tax treaties with other
countries
The OECD has developed a model tax convention
One way of avoiding double taxation is tax credits

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

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Country risk
Country risk arises because of the possibility of
losses due to country-specific economic, political and
social events
It encompasses political risk and sovereign risk

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Sovereign risk
The possibility of losses on claims on foreign
governments and their agencies

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

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Political risk: confiscation


Confiscation does not involve proper compensation
Expropriation implies compensation

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Incorporating country risk into capital


budgeting
Adjusting expected cash flows or the discount rate
Measuring the effects of country risk as the value of
an insurance policy
Using option pricing to derive the price of country risk

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

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Setting transfer prices

Tax considerations
Global regulation
Management incentives and performance evaluation
Marketing considerations and competition

(cont.)
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Setting transfer prices (cont.)

Risk and uncertainty


Government policies
The interests of joint venture partners
The negotiating power of the subsidiary

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