8
Motives for DFI
Cost-Related Motives * Use foreign technology. * React to exchange rate movements, such as when the foreign currency appears to depreciate. DFI can also help reduce the MNC’s exposure to exchange rate fluctuations.
Chapter 10
Direct Foreign Investment
2
Objectives
The main purpose of this chapter is to illustrate why MNCs often use DFI and to suggest various factors involved in the DFI decision. This chapter covers in general terms as to the costs and benefits of DFI, ( the specifics involved in quantifying costs and benefits will be discussed in the following chapter). This chapter implicitly suggests that each firm may benefit from DFI by capitalizing on some unique perceived advantages of the foreign market. Yet, all DFI decisions relate to the MNC’s overall risk and return objectives. The specific objectives are :
12
Diversification Benefits for Merrimack Co.
Merrimack Co. is a U.S. firm that is considering the location of a new investment project. Characteristics of Proposed Project If Located in the U.S. the U.K 25% 25% .09 .80 .11 .02
Part IV
Long-Term Asset and Liability Management
Existing Host Country Tax Laws
Potential Revision in Host Country Tax Laws or Other Provisions
MNC’s Access to Foreign Financing International Interest Rates on Long-Term Funds
4
Topics for Pre-class Discussion
• Why would a large advanced MNC consider DFI in some less developed country? • Assume that you produce plastic computer pieces for computer companies. The pieces require very little technology. Where would you like to establish DFI? • What factors would be considered when deciding whether a subsidiary should reinvest earnings or remit them to the parent? • The DFI decision is related to marketing, finance, and management. What is the role of each area in the DFI decision? • Do you think foreign investments are primarily intended to reduce production costs or increase sales? Discuss.
10
Motives for DFI
• Before investing in a foreign country, the potential benefits must be weighed against the costs and risks. • Financial market conditions should be considered along with product markets when making DFI decisions. • As conditions change over time, some countries may become more attractive targets for DFI, while other countries become less attractive.
• If the new project is located in the U.K., the portfolio variance for the overall firm
= W2Aσ
2A +W2B
σ
2B +2
WA WBORRAB
= (.70) 2(.10) 2 +(.30) 2(.11) 2 +2(.70)(.30)(.10)(.11)(.02) = .0060814 • Thus, as a whole, Merrimack will generate more stable returns if the new project is located in the U.K. 16
Exchange Rate Projections Country Risk Analysis MNC’s Cost of Capital Risk Unique to Multinational Project
Estimated Cash Flows of Multinational Project Multinational Capital Budgeting Decisions Required Return on Multinational Project
Project’s mean expected annual after-tax return Standard deviation of project’s return Correlation of project’s return with return on existing U.S. business
5
Motives for DFI
• DFI can improve profitability and enhance shareholder wealth, either by boosting revenues or reducing costs. Revenue-Related Motives * Attract new sources of demand, especially when the potential for growth in the home country is limited.
= W 2A
σ
2A +W2B
σ
2B +2
WA WB
σ σ
A
B
CORRAB
= (.70) 2(.10) 2+(.30) 2 (.09) 2 +2(.70)(.30)(.10)(.09)(.80) = .008653
15
Diversification Benefits for Merrimack Co
11
Benefits of International Diversification
• The key to international diversification is to select foreign projects whose performance levels are not highly correlated over time. • Example: P324 - 325
6
Motives for DFI
Revenue-Related Motives * Enter profitable markets. * Exploit monopolistic advantages, especially for firms that possess resources or skills not available to competing firms. * React to trade restrictions. * Diversify internationally.
13
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 located in the U.S.
3
Objectives
• to describe common motives for initiating direct foreign investment (DFI); and • to illustrate the benefits of international diversification.