Chapter 16

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
Copyright  2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
16-2
Definition
• An investment project is classified as direct

investment if the investor acquires ‘significant control’
over a firm

16-3
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

16-4
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

16-5
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

16-6
Choice between exporting and FDI
• Profitability
• Opportunities for market growth
• Production cost levels
• Economies of scale

16-7
Licensing
• This involves the supply of technology and know-

how 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

16-8
Franchising
• Companies with brand-name products move offshore

by granting foreigners the exclusive right to sell their
products in a designated area

16-9
Types of FDI
• Greenfield investment
• Brownfield investment
• Mergers and acquisitions
• Joint ventures

16-10
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.)
16-11
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

16-12
Theories of FDI
• A number of theories or hypotheses have been put

forward to explain FDI

16-13
The differential rates of return hypothesis
• Capital flows from countries with low rates of return

to countries with high rates of return

16-14
The diversification hypothesis
• The choice among various projects is determined by

expected return and risk

16-15
The output and market size hypothesis
• The volume of direct investment in one host country

depends on sales or market size

16-16
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.

16-17
The internalisation hypothesis
• FDI arises from efforts by firms to replace market

transactions with internal transactions

16-18
The location hypothesis
• FDI exists because of the international immobility of

some factors of production

16-19
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

16-20
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

16-21
The oligopolistic reaction hypothesis
• FDI by one firm triggers similar investment by other

leading firms in an attempt to maintain market share

16-22
The internal financing hypothesis
• FDI is determined by the foreign subsidiaries’

internally generated funds

16-23
The currency areas hypothesis
• Countries with strong currencies tend to be sources

of FDI
• Countries with weak currencies tend to be recipients
of FDI

16-24
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

16-25
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

16-26
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

16-27
Government regulations
• Regulations may provide incentives

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

16-28
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.)
16-29
Strategic and long-term factors (cont.)
• The desire to induce the host country into a long-

term 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

16-30
Evaluating direct investment projects
• Accounting rate of return

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

16-31
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

16-32
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

16-33
Net present value
Ct n
NPV  C0   t
t 1 (1  r )
 E  E  D  D
r  r   r
 E  D  E  D

16-34
Internal rate of return
Ctn
 C0   t
0
t 1 (1  r )

16-35
Adjusting project assessment for risk
• Risk-adjusted discount rate

• Risk-adjusted cash flows
• Sensitivity analysis

16-36
Evaluating FDI projects
• Two problems:
(i) Measurement of cash flows
(ii) Choice of discount rate

16-37
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

16-38
Forecasting cash flows
• Demand for the product

• Price of the product
• Variable costs
• Fixed costs
• Project lifetime
(cont.)
16-39
Forecasting cash flows (cont.)
• Salvage value
• Remittance restrictions
• Tax rates and laws
• Exchange rates

16-40
The evaluation process
• Estimating incremental cash flows

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

16-41
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

16-42
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

16-43
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

16-44
International taxation
• This is the taxation of cross-border transactions

• Double taxation arises if income earned abroad is
taxed at home and abroad

16-45
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

16-46
Types of taxes
• Corporate income tax

• Withholding taxes
• Indirect taxes
• Import duties
• Taxes on FX gains

16-47
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

16-48
Tax havens
• A tax haven is a place where foreigners may receive

income or own assets without paying taxes on them

16-49
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

16-50
Sovereign risk
• The possibility of losses on claims on foreign

governments and their agencies

16-51
Political risk
• The possibility of losses due to changes in the rules

governing FDI, as well as adverse political
developments

16-52
Political risk: confiscation
• Confiscation does not involve proper compensation

• Expropriation implies compensation

16-53
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

16-54
Transfer pricing
• The pricing of goods and services that are bought

and sold (transferred) between members of a
corporate family

16-55
Setting transfer prices
• Tax considerations
• Global regulation
• Management incentives and performance evaluation
• Marketing considerations and competition
(cont.)
16-56
Setting transfer prices (cont.)
• Risk and uncertainty

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

16-57

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Chapter 16

Foreign Direct Investment

• To discuss the characteristics of FDI

Copyright  2010 McGraw-Hill Australia Pty Ltd

• An investment project is classified as direct

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Rapid growth and changing pattern of FDI

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Export of the goods produced in the source country

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• This involves the supply of technology and know-

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Companies with brand-name products move offshore

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• A number of theories or hypotheses have been put

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Capital flows from countries with low rates of return

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The choice among various projects is determined by

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The volume of direct investment in one host country

Copyright  2010 McGraw-Hill Australia Pty Ltd

• A firm indulges in FDI despite inter-country

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FDI arises from efforts by firms to replace market

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FDI exists because of the international immobility of

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Three conditions must be satisfied if a firm is to

Copyright  2010 McGraw-Hill Australia Pty Ltd

• When a product is standardised, the innovator may

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FDI by one firm triggers similar investment by other

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FDI is determined by the foreign subsidiaries’

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Countries with strong currencies tend to be sources

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FDI arises from the desire to diversify through two

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Lack of political stability discourages FDI inflows

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Tax policies affect incentives to engage in FDI

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Regulations may provide incentives

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The desire to defend foreign markets against

• The desire to induce the host country into a long-

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Accounting rate of return

Copyright  2010 McGraw-Hill Australia Pty Ltd

• This is the percentage return on capital

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The payback period measures how quickly the cost