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 knowhow 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 longterm 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
t
t 1 (1 r )
n
NPV C0
E E D D
r
r
r
E D
E D

16-34
Internal rate of return
Ct
C0
0
t
t 1 (1 r )
n

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

Chapter 16

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 16

Uploaded by

Copyright:

Available Formats

Chapter 16

Foreign Direct Investment

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

What is significant control?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Reasons for interest in FDI

Copyright 2010 McGraw-Hill Australia Pty Ltd

Modes of foreign market entry

Export of the goods produced in the source country

Copyright 2010 McGraw-Hill Australia Pty Ltd

Choice between exporting and FDI

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Choice between greenfield investment and

Choice between greenfield investment and

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

The differential rates of return hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The diversification hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The output and market size hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The industrial organisation hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The internalisation hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The location hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The eclectic theory

Copyright 2010 McGraw-Hill Australia Pty Ltd

The product life cycle hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The oligopolistic reaction hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The internal financing hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

The currency areas hypothesis

Copyright 2010 McGraw-Hill Australia Pty Ltd

Diversification with barriers to capital flows

Copyright 2010 McGraw-Hill Australia Pty Ltd

Political stability and risk

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Strategic and long-term factors

Strategic and long-term factors (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Evaluating direct investment projects

Accounting rate of return

Copyright 2010 McGraw-Hill Australia Pty Ltd

Accounting rate of return

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Net present value

Copyright 2010 McGraw-Hill Australia Pty Ltd

Internal rate of return

Copyright 2010 McGraw-Hill Australia Pty Ltd

Adjusting project assessment for risk

Copyright 2010 McGraw-Hill Australia Pty Ltd

Evaluating FDI projects