MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit III: Financial Management of Multinational Firm
Lesson 3.3
(Foreign Direct Investments )

Foreign Direct Investment
Introduction
In imperfect market conditions, multinational corporations
(MNCs) taking advantage of their supremacy over the rivals
in terms of cost, quality, speed and flexibility vigorously
endeavour to expand their operations in different potential
countries and for that matter adopt entry strategies based
on SWOT analysis and choose a particular mode of entry.
Foreign direct investment (FDI), which involves building
productive capacity directly in a foreign country, is one of
the most important modes of entry into foreign markets.
MNCs conduct FDI through joint ventures with foreign
firms, cross-border mergers and acquisitions, and formation
of new foreign subsidiaries.
Foreign Direct Investment
In foreign direct investment, the parent company
builds productive capacity in a foreign country. In
a cross-border acquisition, a domestic parent
acquires the use of an asset in a foreign company.
A company can acquire productive capacity in a
foreign country in one of the two ways, viz; cross-
border acquisition of assets and cross-border
acquisition of stock.
Foreign Direct Investment
Cross-border acquisition of assets is the most
straightforward method of acquiring productive
capacity because only the asset is acquired
without the transfer of liabilities to the purchaser.
As against this, in a cross-border acquisition of
stock, an MNC buys an equity share in a foreign
company. In a cross-border merger, two firms pool
their assets and liabilities to form a new
organization.
Factors affecting growth of FDI
Some of the factors which can explain the growth of FDI in
developing countries are as follows:

Product and Market imperfections: MNCs possessing specific
intangible capital in the form of trade marks, patents, general
marketing skills, and other organizational abilities may be inspired
to make overseas investment through new product development
and adaptation. At times, MNCs prefer FDI to other modes of
entry into overseas markets for protecting misuse of their
intangible assets by local firms. Coca-Cola chose FDI as a mode of
entry into foreign markets, and set up bottling plants instead of
licensing local firms mainly to protect the formula for its famed
soft drink. If the company licenses a local firm to produce coke, it
has no guarantee that the secrets of the formula will be
maintained.
Factors affecting growth of FDI
Market Opportunities: Existence of tremendous
market opportunities abroad and fiercely
competitive domestic market limiting the growth in
demand and the consequent decline in market
share may stimulate MNCs to enter into high-
potential overseas markets. For instance, many of
the developing countries, viz; Argentina, China,
Mexico, Chile and Hungary have, of late, been able
to attract FDI flows because of existence of
attractive markets.
Factors affecting growth of FDI
Trade Barriers: Because of government created
restrictions in the form of tariffs, quotas, etc. on
imports and exports hindering the free flow of the
products across national boundaries, a firm may
decide to set up production plants in such
countries as means of circumventing the trade
barriers.
Factors affecting growth of FDI
Existence of Superior Profits in Overseas Markets:
Possibility of making superior earnings in certain
overseas market may also allure the MNCs to divert
their funds in these markets, However, MNCs are
likely to face competitive challenge from the local
firms who may prevent a new competitor from
taking their business by lowering their prices.
Factors affecting growth of FDI
Imperfect Labour Market: The labour market is the
most imperfect among all the factors of
production, and labour costs vary widely in
different countries. Wage costs in Mexico, Malaysia
and India are relatively much lower. Substantially
lower labour costs in these countries have
attracted many MNCs .
Factors affecting growth of FDI
Access to Inputs: Due to transport costs, MNCs generally
avoid importing raw materials from a country where it is not
available at a stable price, especially when they plan to sell
the finished product to consumers of that very country.
Under the circumstances, it would be pertinent to set up
production plants in the country where the raw materials are
easily available in abundance.

Access to Foreign Technology: MNCs are growingly setting
up manufacturing plants or acquiring existing plants in those
countries just to learn about the advanced technology and
use them to improve their own production process at their
subsidiary plants around be globe.
Factors affecting growth of FDI
Behaviour of Foreign Exchange Rate: FDI decisions
of MNCs are also influenced by exchange rate
movements because cost is one of the key
determinants. Firms may be tempted to invest in a
country whose currency is perceived by a firm to
be undervalued as the initial investment outlay
would be low.
At times, FDI is driven by the firm's desire to offset
the changing demand for its exports owing to
exchange rate fluctuations.