Final Exam Study Notes - Chapter 7-Foreign Direct Investment

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12 Oct 2010

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MGT491 FINAL EXAM NOTES ± Chapter 7: Foreign Direct Investment
x Foreign direct investment (FDI) ± when a firm invests directly in facilities to produce or market a product in a foreign
x Ex. Occurs whenever a US citizen, organization, or affiliated group takes an interest of 10% or more in a foreign
business entity.
x Once a firm undertakes FDI, it becomes a multinational enterprise
x 2 main forms of FDI:
o Greenfield investment ± involves the establishment of a new operation in a foreign country
o Acquiring or merging with an existing firm in the foreign country
Acquisitions can be as a minority (where the foreign firm takes a 10%-49% interest in the firm),
majority (foreign interest of 50%-99%) or full outright stake (foreign interest of 100%).
Foreign Direct Investment in the World Economy
x Flow of FDI ± refers to the amount of FDI undertaken over a given time period (usually a year)
x Stock of FDI ± total accumulated value of foreign-owned assets at a given time
x Outflows of FDI ± flow of FDI out of a country
x Inflows of FDI ± flow of FDI into a country
Trends in FDI
x Past 30 years ± increase in flow and stock of FDI in the world economy
x The flow of FDI has been accelerating faster than the world trade and world output
o Despite the general decline in trade barriers over the past 30 years, business firms still fear protectionist
pressures ± executives see FDI as a way of circumventing future trade barriers
o Much of the recent increase in FDI is driven by the political and economic changes that are occurring in many
RIWKHZRUOVGHYHORSLQJQDWLRQV± general shift toward democratic political institutions and free market
economies has encouraged FDI
o Asia, Eastern Europe, Latin America ± economic growth, economic deregulation, privatization programs open
to foreign investors, and removal of many restrictions have made these countries more attractive to foreign
Since 2002 ± Latin America has had less favorable regulations that make FDI less welcome
o General desire of governments to facilitate FDI has also been reflected in the increase in number of bilateral
investment treaties designed to protect and promote investment between two countries
o Globalization of the world economy also having a positive impact on the volume of FDI - the whole world is
of the world
o Many firms also believe it is important to have production facilities based close to their major customers,
creates pressure for greater FDI
The Direction of FDI
x Historically most FDI has been directed at the developed nations as firms based in advanced countries invested in
x US has been an attractive target for FDI because of its large and wealthy domestic markets, dynamic and stable
economy, favorable political environment, openness of the country to FDI
x Developed nations of the European Union are also recipients of significant FDI inflows
x FDI into developing nations has increased ± much of this accounted for by growing importance of China as a recipient
of FDI (see p. 245)
x Latin America is the next most important region in the developing world for FDI inflows
o Mexico and Brazil ± historically the two top recipients of inward FDI in Latin America
o Africa usually has the smallest amount of inward investment ± its inability to attract greater investment is in
part a reflection of the political unrest, armed conflict, and frequent changes to economic policy of the region
x Another way to look at importance of FDI inflows is to express them as a percentage of gross fixed capital formation
x Gross Fixed Capital Formation ± summarizes the total amount of capital invested in factories, stores, office buildings,
etc. ± the greater the capital investment in an economy, the more favorable its future growth prospects are likely to be.
In this way, FDI can be seen as an important source of capital investment and determinant of the future growth rate of
an economy.
attractiveness of investing in a nation.
o Ex. Japan and india restrict opportunities for foreign investment in their countries, and they may be hurting
themselves by limiting their access to needed capital investments
The Source of FDI
x US has been largest source country for FDI since WW2
x Other important source countries incl. UK, France, Germany, Netherlands, Japan
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x :RUOVODUJHVWPXOWLQDWLRQDls were US, French, German, British and Japanese ± largely because these were the
most developed nations with largest economies during much of the postwar period and therefore home to many of the
largest and best-capitalized enterprises.
x Many of these countries also often had a long history as trading nations and naturally looked to foreign markets to fuel
their economic expansion
The Form of FDI: Acquisitions vs. Greenfield Investments
x FDI can take the form of a Greenfield investment in a new facility or an acquisition of or merger with an existing local
x Majority of cross-border investment is in the form of mergers and acquisitions rather than Greenfield investments
x FDI flows into developed nations differ markedly from those into developing nations
o Developing nations ± only 1/3 of FDI is cross border mergers and acquisitions, this lower number may reflect
the fact that there are fewer target firms to acquire in developing nations
x Why do firms apparently prefer to acquire existing assets rather than undertake Greenfield investments?
o M & A are quicker to execute than Greenfield investments ± this is important in modern business world where
markets evolve rapidly
o Many firms believe if they do not acquire a desirable target firm, their competition will
o Foreign firms acquired because they have valuable strategic assets such as brand loyalty, customer
relationships, trademarks/patents, distrib systems, production systems, etc. ± easier and less risky for a firm
to acquire these assets than try to build from the ground up through a Greenfield investment.
o Firms believe they can increase the efficiency of the acquired unit by transferring capital, technology and
management skills ± however there is evidence to suggest that many M&A do not meet their anticipated gains
The Shift to Services
x Sector composition of FDI has shifted sharply away from extractive industries and manufacturing, toward services
x Similar trend seen in composition of cross-border M&A ± services are playing a much larger role
x Composition of FDI in services has also changed ± until recently it was concentrated in trade and financial services,
but not industries such as electricity, water, telecom, and business services (ex. IT consulting) are becoming more
x Shift to services driven by 4 factors:
o Reflects the global move in many developed economies away from manufacturing and toward service
o Many services cannot be traded internationally ± need to be produced where they are consumed, FDI is the
principal way to bring services to foreign markets
o Many countries have liberalized their regimes governing FDI n services, which has made large inflows
possible ± ex. Brazil privatizing telecom company and removing restrictions on investment by foreigners in
this sector
o Rise of internet-based global telecom networks has allowed some service enterprises to relocate some of
their value-creation activities to different nations to take advantage of favorable factor costs ± ex. Software
development and testing facilities in india, codes written during the day in the US sent to india to be tested
overnight, by the time the American workers come back in the morning they have results
Theories of Foreign Direct Investment
x Explain why a firm will favor direct investment as a means of entering a market when two other alternatives, exporting
and licensing, are open to it
x Explain why firms in the same industry often undertake foreign direct investment at the same time, and why they favor
certain locations over others as targets for FDI ± explain the observed patterns of FDI flows
x Theoretical perspective ± eclectic paradigm ± attempts to combine the other 2 perspectives into a single holistic
explanation of FDI (eclectic because it combines the best aspects of other theories into a single explanation)
Why FDI?
x Exporting ± involves producing goods at home then shipping them to the receiving country for sale
a royalty fee on every unit sold.
x FDI is expensive and risky compared to exporting or licensing, because firm must bear costs of establishing
production facilities in a foreign country or of acquiring a foreign enterprise, risky because of problems associated with
x Foreign firm undertaking FDI in a country for the first time will be more likely to make costly mistakes due to ignorance
x :KHQDILUPH[SRUWVGRHVQWQHHGWREHDUFRVWVDVVRFLDWHGZLWK)',DQG can reduce risks associated with selling
abroad by using a native sales agent.
x When a firm allows another enterprise to produce its products under license, the licensee bears the costs or risks
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x Why do firms choose FDI over exporting or licensing? Æ examine limitations of exporting and licensing as a means
for capitalizing on foreign market opportunities
x Limitations of Exporting:
o Viability of an exporting strategy often constrained by transportation costs and trade barriers
Unprofitable to ship some products over a large distance
Products that have low value-to-weight ratio are particularly unprofitable to ship, and can be produced
in almost any location (ex. Cement
x For these products the attractiveness of exporting decreases relative to FDI or licensing
Products that have high value-to-weight ratio ± transportation costs are usually a minor component of
total landed cost and have little impact on relative attractiveness of exporting, licensing and FDI
o Some firms undertake FDI as a response to actual or threatened trade barriers such as import tariffs or
By placing tariffs on imported goods, governments can increase the cost of exporting relative to
foreign direct investment and licensing
By limiting imports through quotas, governments can increase the attractiveness of FDI and licensing
Desire to reduce the threat that trade barriers might be imposed is often enough to justify foreign
direct investment as an alternative to exporting
x Limitations of Licensing:
o Internalization theory ± economic theory, seeks to explain why firms often prefer foreign direct investment
over licensing as a strategy for entering foreign markets (known as the market imperfections approach)
According to this theory, 3 major drawbacks to licensing:
x /LFHQVLQJPD\UHVXOWLQDILUPV giving away valuable technological know-how to a potential
foreign competitor
x Licensing does not give the firm tight control over manufacturing, marketing, and strategy in a
foreign country that may be required to maximize its profitability
o Firm may want to retain control over these functions
Firm might want its foreign subsidiary to price and market very aggressively
as a way of keeping a foreign competitor in check, licensee would probably
not accept such an imposition because it would reduce the licenseVSURILW
or might cause the licensee to take a loss
o Wanting control over the operations of a foreign entity ± firm might want to take
advantage of differences in factor costs across countries, producing only part of its
final product in a given country while importing other parts from elsewhere where
they can be produced at a lower cost
Licensee unlikely to accept such an arrangement because it would limit the
o When tight control is desired, foreign direct investment is preferable over licensing
management, marketing, and manufacturing capabilities that produce those products ±
problem is that such capabilities are often not amenable to licensing
o Foreign licensee may be able to physically reproduce the product, but may not be
able to do so as efficiently as the firm could itself, as a result the licensee would not
be able to fully exploit the profit potential inherent in the foreign market
o Ex. Toyota (p. 250)
This suggests that when one or more of the following conditions holds, markets fail as a mechanism
for selling know-how and FDI is more profitable than licensing:
x When a firm has valuable know-how that a licensing contract cannot adequately protect
x When the firm needs tight control over a foreign entity to maximize its market share and
earnings in that country
x :KHQDILUPVVNLOOVDQGNQRZ-how are not amenable to licensing
x Advantages of FDI:
o Firm will favor FDI over exporting as an entry strategy when transportation costs or trade barriers make
exporting unattractive
o Firm will favor FDI over licensing or franchising when it wishes to maintain control over its technological know-
The Pattern of Foreign Direct Investment
x Firms in the same industry often undertake foreign direct investment at around the same time
x There is a clear tendency for firms to direct their investment activities toward certain locations
x 2 theories to explain the patterns observed in FDI flows:
o Strategic behavior
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