Lecture International finance: An analytical approach (3/e): Chapter 16 - Imad A. Moosa

Chapter 16 - Foreign direct investment and international capital budgeting. In this chapter, the learning objectives are: 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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Chapter 16

Foreign Direct Investment and International Capital

Budgeting

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa

Slides prepared by Afaf Moosa

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

16-2

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Definition

• An investment project is classified as direct

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

16-3

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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

16-4

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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

16-5

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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

16-6

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Choice between exporting and FDI

• Profitability

• Opportunities for market growth

• Production cost levels

• Economies of scale

16-7

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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

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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

16-9

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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

16-11

(cont )

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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

16-12

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Theories of FDI

• A number of theories or hypotheses have been put

forward to explain FDI

16-13

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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

16-14

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The diversification hypothesis

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

16-15

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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

16-16

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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.

16-17

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The internalisation hypothesis

• FDI arises from efforts by firms to replace market

transactions with internal transactions

16-18

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The location hypothesis

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

16-19

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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

16-20

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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

16-21

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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

16-22

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The internal financing hypothesis

• FDI is determined by the foreign subsidiaries’

internally generated funds

16-23

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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

16-24

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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

16-25

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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

16-26

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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)

16-28

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Strategic and long-term factors

• The desire to defend foreign markets against

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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

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Evaluating direct investment

projects

• Accounting rate of return

• Payback period

• Net present value (NPV)

• Internal rate of return (IRR)

16-31

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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

16-32

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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

16-33

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Net present value

D E

n

t

r D E

D r

D E

E r

r

C C

NPV

1

0

) 1

(

16-34

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Internal rate of return

0 )

1 (

1 0

16-35

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Adjusting project assessment for

risk

• Risk-adjusted discount rate

• Risk-adjusted cash flows

• Sensitivity analysis

16-36

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Evaluating FDI projects

• Two problems:

(i) Measurement of cash flows

(ii) Choice of discount rate

16-37

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Problems of cash flow

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Forecasting cash flows

• Demand for the product

• Price of the product

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Forecasting cash flows (cont.)

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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

16-41

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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

16-42

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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

16-43

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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

16-44

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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

16-45

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 taxing undistributed earnings at a higher rate

 imputation tax system

16-46

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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

16-48

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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

16-49

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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

16-50

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