Part IV

Long-Term Asset and Liability Management

Existing
Host Country
Tax Laws
Potential Estimated
Revision in Cash Flows of
Exchange Multinational
Host Country Rate
Tax Laws or Project
Projections
Other
Provisions
Country Risk Multinational
Analysis Capital
MNC’s Access Budgeting
to Foreign Decisions
Financing
MNC’s Cost
of Capital Required
International
Interest Rates Return on
on Long-Term Multinational
Funds Risk Unique to Project
Multinational
Project
 Chapter
13
Direct Foreign Investment

South-Western/Thomson Learning © 2006 Slides by Yee-Tien (Ted) Fu

 Chapter Objectives

 To describe common motives for initiating

direct foreign investment (DFI); and
 To illustrate the benefits of international
diversification.

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 Motives for DFI

• MNCs commonly consider DFI because it

can improve their profitability and
enhance shareholder wealth.
• In most cases, MNCs engage in DFI
because they are interested in boosting
revenues, reducing costs, or both.

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 Revenue-Related Motives for DFI
Motives Means of Achieving Benefit
 Attract new sources Establish a subsidiary or acquire
of demand. a competitor in a new market.
 Enter profitable Acquire a competitor that has
markets. controlled its local market.
 Exploit Establish a subsidiary in a market
monopolistic where competitors are unable to
advantages. produce the identical product.
 React to trade Establish a subsidiary in a market
restrictions. where trade restrictions will
adversely affect export volume.
 Diversify Establish subsidiaries in markets
internationally. with different business cycles.
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 Cost-Related Motives for DFI
Motives Means of Achieving Benefit
 Fully benefit from Establish a subsidiary in a new
economies of scale. market where products produced
elsewhere can be sold. This
allows for increased production
and greater production efficiency.
 Use foreign factors Establish a subsidiary in a market
of production. that has lower costs of labor or
land. Sell the products elsewhere.
 Use foreign raw Establish a subsidiary in a market
materials. where raw materials are cheap
and accessible. Sell the products
in that market and elsewhere.
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 Cost-Related Motives for DFI
Motives Means of Achieving Benefit
 Use foreign Participate in a joint venture or
technology. acquire an existing overseas
plant to learn about foreign
production processes, so as to
improve its own operations.
 React to exchange Establish a subsidiary in a new
rate movements. market where the local currency
is weak but is expected to
strengthen over time.

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 Motives for DFI
• The European Union’s recent expansion
enables members to transport products
throughout Europe at reduced tariffs.
• New low-wage members (such as Poland,
the Czech Republic and Romania) were thus
targeted for new DFI by MNCs that wanted
to reduce manufacturing costs.
• However, there is a tradeoff – thousands of
jobs were lost in Western Europe.

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 Comparing the Benefits of DFI
Across Countries
• The optimal method for a firm to penetrate
a foreign market is partially dependent on
the characteristics of the market.
• For example, if the consumers are used to
buying products from local firms, then
licensing arrangements or joint ventures
may be more appropriate.

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 Comparing the Benefits of DFI
Across Countries
• Before investing in a foreign country, the
potential benefits must be weighed against
the costs and risks associated with that
specific country.
• In particular, the MNC will want to review
the foreign country’s economic growth and
other macroeconomic indicators, as well as
the political structure and policy issues.

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 Comparing the Benefits of DFI
Over Time
• As conditions change over time, some
countries may become more attractive
targets for DFI, while other countries
become less attractive.
• Europe (especially Eastern Europe), Latin
America, and Asia now receive a larger
proportion of DFI than in the past.

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 Benefits of International
Diversification
• The key to international diversification is
to select foreign projects whose
performance levels are not highly
correlated over time.
• In this way, the various international
projects are less likely to experience poor
performance simultaneously.

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 Diversification Benefits for
Merrimack Co.
Merrimack Co., a U.S. firm, plans to invest in
a new project in either the U.S. or the U.K.
Characteristics of Proposed
Project If Located in
in the U.S. in the U.K.
Project’s mean expected
annual after-tax return 25% 25%

Standard deviation of
project’s return .09 .11

Correlation of project’s
return with return on .80 .02
existing U.S. business
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 Diversification Benefits for
Merrimack Co.
• In terms of return, neither new project has
an advantage.
• With regard to risk, the new project is
expected to exhibit slightly less variability
in returns if it is located in the U.S.
• However, estimating the risk of the
individual project without considering the
overall firm would be a mistake.

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 Diversification Benefits for
Merrimack Co.
• Suppose that the project will constitute
30% of Merrimack’s total funds invested in
itself, and that the standard deviation of
return on its existing business is .10.
• If the new project is located in the U.S., the
portfolio variance for the overall firm
 w A2σ 2A  w B2σ B2  2w Aw Bσ Aσ BCORRAB
 .70 2.10 2  .30 2.09 2  2 .70  .30 .10 .09  .80 
 .008653
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 Diversification Benefits for
Merrimack Co.
• If the new project is located in the U.K.,
the portfolio variance for the overall firm
 w A2σ 2A  w B2σ B2  2w Aw Bσ Aσ BCORRAB
 .70 .10  .30 .11  2 .70  .30 .10  .11.02
2 2 2 2

 .0060814
• Thus, as a whole, Merrimack will generate
more stable returns if the new project is
located in the U.K.

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 Diversification Analysis of
International Projects
• Like any investor, an MNC with projects positioned around the
world is concerned with the risk and return characteristics of the
projects.
• The portfolio of all projects reflects the MNC in aggregate.

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 Risk-Return Analysis of
International Projects
Expected Return Frontier of efficient
A Project A has
project portfolios
the highest
B expected
C return and
D greatest risk.
G
E F

Risk
• When the projects are combined appropriately,
the project portfolio may be able to achieve a
risk-return tradeoff exhibited by any of the points
on the frontier of efficient project portfolios.
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 Diversification Analysis of
International Projects
• Project portfolios along the efficient frontier
exhibit minimum risk for a given expected
return.
• Of these efficient project portfolios, an MNC
may choose one that corresponds to its
willingness to accept risk.
• The actual location of the frontier of efficient
project portfolios depends on the business
in which the firm is involved.

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 Diversification Analysis of
International Projects
• Some MNCs have frontiers of possible
project portfolios that are more desirable
than the frontiers of other MNCs.
Efficient frontier for
Expected Return

a multiproduct
MNC

Efficient frontier
for a single-
product MNC

Risk
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 Diversification Analysis of
International Projects
• Our discussion suggests that MNCs can
achieve more desirable risk-return
characteristics from their project
portfolios if they sufficiently diversify
among products and geographic markets.

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Comparison of Economic Growth Among Countries

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 Decisions
Subsequent to DFI
• Some periodic decisions are necessary:
¤ Should further expansion take place?
¤ Should the earnings be remitted to the
parent, or used by the subsidiary?
• These decisions should be analyzed on a
case-by-case basis.

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 Host Government View of DFI
• Each government must weigh the
advantages and disadvantages of DFI in
its country.
• The government may provide incentives to
encourage desirable forms of DFI, and
impose preventive barriers or conditions
on other forms of DFI.

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 Incentives to Encourage DFI
• The ideal DFI solves problems such as
unemployment and lack of technology
without taking business away from the
local firms.
• Common incentives offered by host
governments include tax breaks,
discounted rent for land and buildings,
low-interest loans, subsidized energy, and
reduced environmental restrictions.

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 Barriers to DFI
• Governments are less anxious to
encourage DFI that adversely affects local
firms, consumers and the economy.
• DFI barriers include regulations governing
mergers and acquisitions, restrictions on
foreign ownership of local firms, red tape
(procedural and documentation
requirements), the political influence of
local firms, and political instability.

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Government-Imposed Conditions
to Engage in DFI
• Some governments allow international
acquisitions but impose special
requirements on the MNCs that desire to
acquire a local firm.
• Such conditions include environmental
constraints, restrictions on local sales,
and employment requirements.

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