International Financial Management

13th Edition
by Jeff Madura

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 13 Direct Foreign Investment
Chapter Objectives

 Describe common motives for initiating foreign direct

investment.

 Illustrate the benefits of international diversification.

 Describe how the host government can encourage DFI with

incentives for MNCs or discourage DFI by imposing
barriers.

 Explain how MNCs can assess their potential DFI projects

to determine which projects should be given serious
consideration.
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 Motives for Direct Foreign Investment (1 of 4)

Revenue-Related Motives
 Attract new sources of demand
MNCs commonly pursue DFI in countries experiencing economic
growth so that they can benefit from the increased demand for
products and services there.
 Enter profitable markets
When similar industries are generating very high earnings in a
particular country, an MNC may decide to sell its own products in
those markets.
 Exploit monopolistic advantages
Firms possessing resources or skills not available to competing firms
may attempt to exploit it internationally.

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 Motives for Direct Foreign Investment (2 of 4)

Revenue-Related Motives (cont.)

 React to trade restrictions
MNCs may pursue DFI to circumvent trade barriers.
 Diversify Internationally
By diversifying sales (and possibly even production)
internationally, a firm can make its net cash flows less volatile.

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 Motives for Direct Foreign Investment (3 of 4)

Cost Related Motives

 Fully benefit from economies of scale
Lower average cost per unit resulting from increased production.
 Use foreign factors of production
Labor and land costs can vary dramatically among countries.
 Use foreign raw materials
Develop the product in the country where the raw materials are
located.
 Use foreign technology
 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.
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 Motives for Direct Foreign Investment (4 of 4)

Comparing Benefits of DFI among Countries

 Though disadvantages of DFI may exist, MNCs can compare
benefits of DFI among countries and use DFI to achieve those
benefits. (Exhibit 13.1)
Measuring and MNC’s Benefits of DFI
 MNCs measure the benefits of DFI by following the steps in
Exhibit 13.2
 MNCs apply a multinational capital budgeting process to compare the
benefits and costs of international projects.
 This capital budgeting analysis commonly involves international
restructuring and an assessment of risk characteristics in the country
where the proposed projects are to be implemented.
 It also requires an assessment of the cost of capital and debt financing
possibilities.
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 Exhibit 13.1 Summary of Motives for Direct Foreign
Investment

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 Benefits of International Diversification (1 of 2)

Select foreign projects whose performance levels are not

highly correlated over time.
 p2  wA2 A2  wB2 B2  2wA wB A B CORR AB
w  proportion of total funds in investment s A or B
σ  standard deviation of returns on investment s A or B
CORR  correlatio n coefficien t of returns A and B

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 Exhibit 13.2 Evaluation of Proposed Projects in Alternative
Locations

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 Benefits of International Diversification (2 of 2)

Diversification Analysis of International Projects

 Comparing portfolios along the frontier of efficient projects
(See Exhibit 13.3)
 Comparing frontiers among MNCs (See Exhibit 13.4)
Diversification Among Countries
 Exhibit 13.6 shows how the stock market values of various
countries have changed over time.
 A country’s stock market value reflects the expectations of
business opportunities and economic growth.

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 Exhibit 13.3 Risk-Return Analysis of International Projects

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 Exhibit 13.4 Risk-Return Advantage of a Diversified MNC

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 Host Government Views of DFI (1 of 4)

Incentives to encourage DFI

 The ideal DFI solves problems such as unemployment and lack of
technology without taking business away from local firms.
 Governments are particularly willing to offer incentives for DFI that
will result in the employment of local citizens or an increase in
technology.

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 Host Government Views of DFI (2 of 4)

Barriers to DFI
 Protective barriers — Agencies may prevent an MNC from
acquiring companies if they believe employees will be laid off
 “Red Tape” barriers — Procedural and documentation
requirements
 Industry barriers — Local firms may have substantial
influence on the government and may use their influence to
prevent competition from MNCs
 Environmental barriers — Building codes, disposal of
production waste materials, and pollution controls

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 Host Government View of DFI (3 of 4)

Barriers to DFI
 Regulatory barriers — Each country enforces its own
regulatory constraints pertaining to taxes, currency
convertibility, earnings remittance, employee rights, and other
policies.
 Ethical differences — A business practice that is perceived to
be unethical in one country may be ethical in another.
 Political instability — If a country is susceptible to abrupt
changes in government and political conflicts, the feasibility of
DFI may be dependent on the outcome of those conflicts.

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 Host Government View of DFI (4 of 4)

Government-imposed conditions to engage in DFI

 Some governments allow international acquisitions but impose
special requirements on MNCs that desire to acquire a local firm.

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 SUMMARY (1 of 3)

 MNCs may be motivated to initiate direct foreign investment

in order to attract new sources of demand or to enter markets
where superior profits are possible. These two motives are
normally based on opportunities to generate more revenue in
foreign markets. Other motives for using DFI are typically
related to cost efficiency, such as using foreign factors of
production, raw materials, or technology. In addition, MNCs
may engage in DFI to protect their foreign market share, to
react to exchange rate movements, or to avoid trade
restrictions.

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 SUMMARY (2 of 3)

 International diversification is a common motive for direct

foreign investment. It allows an MNC to reduce its exposure to
domestic economic conditions. In this way, the MNC may be
able to stabilize its cash flows and reduce its risk. Such a goal
is desirable because it may reduce the firm’s cost of financing.
International projects may allow MNCs to achieve lower risk
than is possible from only domestic projects without reducing
their expected returns. International diversification tends to be
better able to reduce risk when the DFI is targeted to countries
whose economies are somewhat unrelated to an MNC’s home
country economy.

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 SUMMARY (3 of 3)

 Some host governments boost DFI in its country by offering

incentives to MNCs, such as tax breaks. However, host
governments sometimes impose barriers to DFI if they are
concerned that the DFI might adversely affect local
competitors or the environment.
 When an MNC considers a specific form of DFI, it must
measure the potential benefits, including possible
diversification benefits and host government incentives. It
must also consider country barriers that make the DFI more
risky. If its initial assessment leads to a conclusion that DFI
might be worthwhile, it can then apply a capital budgeting
analysis to determine whether DFI is feasible, as described in
the following chapter.
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