Course International Financial Management

Topic FOREIGN DIRECT INVESTMENT

Faculty Kshama M S
 Learning Objectives

At the end of this session, you will be able to:

➢ Learning Objective 1: Introduction to Foreign Direct Investment

➢ Learning Objective 2: Theories & Strategies of Foreign Direct Investment

➢ Learning Objective 3: Cost & Benefits of Foreign Direct Investment

➢ Learning Objective 4: Motives for Foreign Direct Investment

 FOREIGN DIRECT INVESTMENT
INTRODUCTION
MNCs commonly capitalize on foreign business opportunities by
engaging in direct foreign investment (DFI), which is investment in
real assets (such as land, buildings, or even existing plants) in
foreign countries. They engage in joint ventures with foreign firms,
acquire foreign firms, and form new foreign subsidiaries. Any of
these types of DFI can generate high returns when managed
properly.

However, DFI requires a substantial investment and can therefore

put much capital at risk. Moreover, if the investment does not
perform as well as expected, the MNC may have difficulty selling
the foreign project it created.

Given these return and risk characteristics of DFI, MNCs tend to

carefully analyze the potential benefits and costs before
implementing any type of DFI.
 THEORIES OF FOREIGN DIRECT INVESTMENT
Mac Dougall -Kemp Hypothesis:
This theory was developed by MacDougal (1958) and was later elaborated by Kemp (1964).
FDI moves from capital abundant economy to capital scarce economy till the marginal production
is equal in both countries.

Industrial Organization Theory

Krugman (1989) - According to this theory, MNC with superior technology moves to different
countries to supply innovated products making in turn ample gains.

Currency Based Approaches

A firm moves from strong currency country to weak currency country. Aliber (1971) postulates
that firms from strong currency countries move out to weak currency countries. Froot and Stain
(1989) holds that, depreciation in real value of currency of a country lowers the wealth of a
domestic residents
 THEORIES OF FOREIGN DIRECT INVESTMENT
Location-Specific Theory
Hood and Young (1979) stress on the location factor. According to them, FDI moves to a countries
with abundant raw materials and cheap labor force.

Product Cycle Theory

FDI takes place only when the product in question achieves specific stage in its life cycle-
introduction, growth, maturity and decline stage. At maturity stage, the demand for new product
in developed countries grow substantially and rival firms begin to emerge producing similar
products at lower price.

Political-Economic Theories
They concentrate on the political risks. Political stability in the host country leads to FDI (Fatehi-
Sedah and Safizeha 1989). Similarly, political instability in the home country encourages FDI in
other countries (Tallman 1988).
 STRATEGY FOR FOREIGN DIRECT INVESTMENT
Firm-Specific Strategy
It means offering new kind of product or differentiated product. When product innovation fails to
work, a firm may adopt product differentiation strategy. This is done through putting trade mark
on the product or branding. Sometimes a firm may adopt different brands for different markets
to make them suitable for local markets. for example
Bata, operates in 92 countries under the same trade mark, while
Uniliver‘s low - leather fabric washing product is marketed is market under five different brands
in Western Europe.
 STRATEGY FOR FOREIGN DIRECT INVESTMENT
Cost-Economic Strategy
This strategy is done through lowering cost by moving the firm to the places where there are
cheap factors of production
Example: labour and raw materials

Joint Venture with a Rival Firm

Sometimes when a rival firm in a host country is so powerful that it is not easy for MNC to
compete, the later prefer to join hands with the host country firm for a joint venture agreement
and the MNC is able to operate the host country market.

Investment Mode Strategy

This strategy depends on the mode of investment favoured by the host country. It depends also
on the political and economic environment of the host country. If the host government does not
favour a particular mode, an investing company cannot adopt it even if it is the most suitable.
 COSTS AND BENEFITS OF FOREIGN DIRECT INVESTMENT
A cost-benefit analysis is a process by which business decisions are
analysed. The benefits of a given situation or business-related action are
summed, and then the costs associated with taking that action are
subtracted.

Cost and benefits of FDI can be classified as two:

• Cost and Benefits of the Host Country
• Cost and Benefits of the investing MNC
 COSTS AND BENEFITS OF FOREIGN DIRECT INVESTMENT – HOST COUNTRY
Costs of the Host Country
✓ Cultural and political interference.

✓ Unhealthy competition to Domestic players

✓ Over utilization of local resources (both natural and human resources)

✓ Violation of human rights

✓ Threat to indigenous technology.

✓ Threat to local products.

 COSTS AND BENEFITS OF FOREIGN DIRECT INVESTMENT – HOST COUNTRY
Benefits of Host Country

✓ Improving the balance of payments

✓ Providing employment

✓ Source of tax revenue

✓ Technology transfer
 COSTS AND BENEFITS OF FOREIGN DIRECT INVESTMENT – INVESTING MNC
Costs to Investing MNCs

✓ Risk from Political Changes.

✓ Hindrance to Domestic Investment.

✓ Economic Non-Viability.
 COSTS AND BENEFITS OF FOREIGN DIRECT INVESTMENT – INVESTING MNC
Benefits of Investing MNCs

✓ Access to markets

✓ Access to resources

✓ Reduces cost of production

 MOTIVES FOR DIRECT FOREIGN INVESTMENT
MNCs commonly consider direct foreign investment 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).
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - REVENUE-RELATED MOTIVES
The following are typical motives of MNCs that are attempting to boost
revenues:

a). Attract new sources of demand.

A corporation often reaches a stage when growth is limited in its home country,
possibly because of intense competition. Even if it faces little competition, its
market share in its home country may already be near its potential peak. Thus, the
firm may consider foreign markets where there is potential demand.
MOTIVES FOR DIRECT FOREIGN INVESTMENT - REVENUE-RELATED MOTIVES
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - REVENUE-RELATED MOTIVES
b) Enter profitable markets.
If other corporations in the industry have proved that superior earnings can be realized in other
markets, an MNC may also decide to sell in those markets. It may plan to undercut the prevailing,
excessively high prices.

c) Exploit monopolistic advantages.

Firms may become internationalized if they possess resources or skills not available to competing
firms. If a firm possesses advanced technology and has exploited this advantage successfully in
local markets, the firm may attempt to exploit it internationally as well.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - REVENUE-RELATED MOTIVES

d) React to trade restrictions.

In some cases, MNCs use DFI as a defensive rather than an aggressive strategy. Specifically,
MNCs may pursue DFI to circumvent trade barriers.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - REVENUE-RELATED MOTIVES
e) Diversify internationally.
By diversifying sales (and possibly even production) internationally, a firm can make its net cash
flows less volatile. Thus, the possibility of a liquidity deficiency is less likely. In addition, the firm
may enjoy a lower cost of capital as shareholders and creditors perceive the MNC’s risk to be
lower because of more stable cash flows.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - COST-RELATED MOTIVES
MNCs also engage in DFI in an effort to reduce costs. The following are typical motives of
MNCs that are trying to cut costs:

a) Fully benefit from economies of scale.

A corporation that attempts to sell its primary product in new markets may increase its earnings
and shareholder wealth due to economies of scale (lower average cost per unit resulting from
increased production). Firms that utilize much machinery are most likely to benefit from
economies of scale.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - COST-RELATED MOTIVES
b) Use foreign factors of production.
Labour and land costs can vary dramatically among countries. MNCs often attempt to set up
production in locations where land and labour are cheap. Thus, it is worthwhile for MNCs to
survey markets to determine whether they can benefit from cheaper costs by producing in those
markets.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - COST-RELATED MOTIVES
c) Use foreign raw materials.
Due to transportation costs, a corporation may attempt to avoid importing raw materials from a
given country, especially when it plans to sell the finished product back to consumers in that
country. Under such circumstances, a more feasible solution may be to develop the product in the
country where the raw materials are located.

d) Use foreign technology.

Corporations are increasingly establishing overseas plants or acquiring existing overseas plants
to learn about unique technologies in foreign countries. This technology is then used to improve
their own production processes and increase production efficiency at all subsidiary plants around
the world.
 MOTIVES FOR DIRECT FOREIGN INVESTMENT - COST-RELATED MOTIVES
e) React to exchange rate movements.
When a firm perceives that a foreign currency is undervalued, the firm may consider DFI in that
country, as the initial outlay should be relatively low.
A related reason for such DFI is to offset the changing demand for a company’s exports due to
exchange rate fluctuations.

For example, when Japanese automobile manufacturers build plants in the United States, they
can reduce exposure to exchange rate fluctuations by incurring dollar costs for their production
that offset dollar revenues.
SUMMARY OF MOTIVES FOR DIRECT FOREIGN INVESTMENT
 BARRIERS TO FOREIGN DIRECT INVESTMENT
Governments are less anxious to encourage DFI that adversely affects locally owned
companies, unless they believe that the increased competition is needed to serve
consumers. Therefore, they tend to closely regulate any DFI that may affect local firms,
consumers, and economic conditions.
✓ Protective Barriers
✓ “Red Tape” Barriers
✓ Industry Barriers
✓ Environmental Barriers
✓ Regulatory Barriers.
✓ Ethical Differences.
✓ Political Instability
 Summary

Key points discussed in this session:

➢ The Concept of Foreign Direct Investment

➢ Various Theories & Strategies used in Foreign Direct Investment

➢ Cost & Benefits of Foreign Direct Investment to Host & MNC’s

➢ Revenue & Cost related Motives for Foreign Direct Investment

 References
Book References:
➢ International Finance: Theory and Policy, Global Edition-Krugman Paul R; Obstfeld Maurice; Melitz J Marc
➢ International Financial Management, Eleventh Edition by Jeff Madura
➢ International Finance: Fourth Edition by Maurice D. Levi
➢ International Financial Management, Second Edition by Geert Bekaert, Robert Hodrick

E References:
https://www.investopedia.com/terms/f/fdi.asp