chapter13-14.pdf - Howard Assignments

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13 Direct Foreign Investment

 Describe common motives for initiating foreign direct investment

 Illustrate the benefits of international diversification

Chapter Objectives

Motives for Direct Foreign Investment: 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.

 React to trade restrictions MNCs may pursue DFI to circumvent trade barriers.

 Diversity Internationally By diversifying sales (and possibly even production) internationally, a firm can make itsnet cash flows less volatile.

Motives for Direct Foreign Investment: 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.

Benefits of DFI

 Though disadvantages of DFI may exist, MNCs can compare benefits of DFI among countries and use DFI to achieve those benefits (Exhibit 13.1).

 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.

Exhibit 13.1 Summary of Motives for Direct Foreign Investment

Exhibit 13.2 Steps Taken by MNCs to Determine Whether to Pursue Direct Foreign Investment

Exhibit 13.4 Risk-Return Analysis of International Projects

Exhibit 13.6 Comparison of Expected Economic Growth among Countries: Annual Stock Market Return

Host Government View of DFI

 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.

Host Government View of DFI (Cont.)

 Barriers to DFI a. Protective barriers – agencies may prevent an MNC from

acquiring companies if they believe employees will be laid off.

b. Red tape barriers – procedural and documentation requirements

c. Industry barriers – local firms may have substantial influence on the government and may use their influence to prevent competition from MNCs

d. Environmental barriers – building codes, disposal of production waste materials, and pollution controls.

e. Regulatory barriers – each country enforces its own regulatory constraints pertaining to taxes, currency convertibility, earnings remittance, employee rights, and other policies

Host Government View of DFI (Cont.)

d. Ethical differences – a business practice that is perceived to be unethical in one country may be ethical in another.

e. 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.

 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.

SUMMARY

 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.

SUMMARY (Cont.)

 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.

14 Multinational Capital Budgeting

 Compare the capital budgeting analysis of an MNC’s subsidiary versus its parent

 Demonstrate how multinational capital building can be applied to determine whether an international project should be implemented

 Show how multinational capital budgeting can be adapted to account for special situations such as alternative exchange rate scenarios or when subsidiary financing is considered

 Explain how the risk of international projects can be assessed

Chapter Objectives

Subsidiary versus Parent Perspective

1. Tax Differentials: different tax rates may make a project feasible from a subsidiary’s perspective, but not from a parent’s perspective.

2. Restrictions on Remitted Earnings: governments may place restrictions on whether earnings must remain in country.

3. Excessive Remittances: if the parent company charges fees to the subsidiary, then a project may appear favorable from a parent perspective, but not from a subsidiary’s perspective.

4. Exchange Rate Movements: earnings converted to the currency of the parent company will be affected by exchange rate movements.

Exhibit 14.1 Process of Remitting Subsidiary Earnings to Parent

Subsidiary versus Parent Perspective

1. The parent’s perspective is appropriate when evaluating a project since the parent’s shareholders are the owners and any project should generate sufficient cash flows to the parent to enhance shareholder wealth.

2. One exception is when the foreign subsidiary is not wholly owned by the parent and the foreign project is partially financed with retained earnings of the parent and of the subsidiary.

Input for Multinational Capital Budgeting

An MNC will normally require forecasts of the financial characteristics that influence the initial investment or cash flows of the project.

1. Initial investment – Funds initially invested include whatever is necessary to start the project and additional funds, such as working capital, to support the project over time.

2. Price and consumer demand – Future demand is usually influenced by economic conditions, which are uncertain.

Input for Multinational Capital Budgeting (Cont.)

3. Costs – Variable-cost forecasts can be developed from comparative costs of the components. Fixed costs can be estimated without an estimate of consumer demand.

4. Tax laws – International tax effects must be determined on any proposed foreign projects.

5. Remitted funds – The MNC policy for remitting funds to the parent influences estimated cash flows.

Input for Multinational Capital Budgeting (Cont.)

6. Exchange rates – These movements are often very difficult to forecast.

7. Salvage (liquidation) values – Depends on several factors, including the success of the project and the attitude of the host government toward the project.

8. Required rate of return – The MNC should first estimate its cost of capital, and then it can derive its required rate of return on a project based on the risk of that project.

Other Factors to Consider

 Exchange rate fluctuations  Inflation  Financing arrangement  Blocked funds  Uncertain salvage value  Impact of project on prevailing cash flows  Host government incentives  Real options

Other Factors to Consider

Exchange Rate Fluctuations  Though exchange rates are difficult to forecast, a

multinational capital budgeting analysis could incorporate other scenarios for exchange rate movements, such as a pessimistic scenario and an optimistic scenario.

 Exchange Rates Tied to Parent Currency – Some MNCs consider projects in countries where the local currency is tied to the dollar.

 Hedged Exchange Rates – Some MNCs may hedge the expected cash flows of a new project, so they should evaluate the project based on hedged exchange rates

Other Factors to Consider

Inflation 1. Should affect both costs and revenues. 2. Exchange rates of highly inflated countries

tend to weaken over time. 3. The joint impact of inflation and exchange rate

fluctuations may be partially offsetting effect from the viewpoint of the parent.

Other Factors to Consider

Financing Arrangement Many foreign projects are partially financed by foreign subsidiaries.

1. Subsidiary financing 2. Parent company financing 3. Financing with other subsidiaries’ retained

earnings

Other Factors to Consider

Assume, subsidiary borrows S$10 million to purchase the previously leased offices. Subsidiary will make interest payments on this loan (of S$1 million) annually and will pay the principal (S$10 million) at the end of Year 4, at termination. Singapore government permits a maximum of S$2 million per year in depreciation for this project, the subsidiary’s depreciation rate will remain unchanged. Assume the offices are expected to be sold for S$10 million after taxes at the end of Year 4. 1. The annual cash outflows for the subsidiary are still the same. 2. The subsidiary must pay the S$10 million in loan principal at the end of 4

years. However, since it receives S$10 million from the sale of the offices, it can use the proceeds of the sale to pay the loan principal.

Financing Arrangement – Subsidiary Financing

Other Factors to Consider

Instead of the subsidiary leasing or purchasing with borrowed funds, the parent uses its own funds to purchase the offices. Thus, its initial investment is $15 million, composed of the original $10 million investment, plus an additional $5 million to obtain an extra S$10 million to purchase the offices. 1. The subsidiary will not have any loan or lease payments. 2. The parent’s initial investment is $15 million instead of $10

million. 3. The salvage value to be received by the parent is S$22

million instead of S$12 million because the offices are assumed to be sold for S$10 million after taxes at the end of Year 4.

Financing Arrangement – Parent Company Financing

Blocked Funds

 In some cases, the host country may block funds that the subsidiary attempts to send to the parent.

 Some countries require that earnings generated by the subsidiary be reinvested locally for at least 3 years before they can be remitted.

Other Factors to Consider

Uncertain Salvage Value The salvage value of an MNC’s project typically has a significant impact on the project’s NPV.

1. Consider scenario analysis to estimate NPV at various salvage values.

2. Consider estimating break-even salvage value at zero NPV.

Breakeven Salvage Value:

Other Factors to Consider

tn k

kCFIOSV )1(

)1(+





+

−= ∑

Impact of Project on Prevailing Cash Flows

1. Impact can be favorable if sales volume of parent increases following establishment of project.

2. Impact can be unfavorable if existing cash flows decline following establishment of project.

Other Factors to Consider

Host Government Incentives may include: 1. Low-rate host government loans 2. Reduced tax rates for subsidiary 3. Government subsidies of initial investment

Other Factors to Consider

Real Options

1. Opportunity to obtain or eliminate real assets

2. Value is influenced by:

a. Probability that real option will be exercised

b. NPV that will result from exercising the real option

Other Factors to Consider

Adjusting Project Assessment for Risk

1. Risk-adjusted discount rate – The greater the uncertainty about a project’s forecasted cash flows, the larger should be the discount rate applied to cash flows.

2. Sensitivity analysis – can be more useful than simple point estimates because it reassesses the project based on various circumstances that may occur.

3. Simulation – can be used for a variety of tasks, including the generation of a probability distribution for NPV based on a range of possible values for one or more input variables. Simulation is typically performed with the aid of a computer package.

SUMMARY

 Capital budgeting may generate different results and a different conclusion depending on whether it is conducted from the perspective of an MNC’s subsidiary or the MNC’s parent. When a parent is deciding whether to implement an international project, it should determine whether the project is feasible from its own perspective.

 The risk of international projects can be accounted for by adjusting the discount rate used to estimate the project’s net present value. However, the adjustment to the discount rate is subjective. An alternative method is to estimate the net present value based on various possible scenarios for exchange rates or any other uncertain factors. This method is facilitated by the use of sensitivity analysis or simulation.

SUMMARY (Cont.)

 Multinational capital budgeting requires any input that will help estimate the initial outlay, periodic cash flows, salvage value, and required rate of return on the project. With these factors, the international project’s net present value can be estimated, just as if it were a domestic project. However, it is normally more difficult to estimate these factors for an international project. Exchange rates create an additional source of uncertainty because they affect the cash flows ultimately received by the parent as a result of the project. Other international conditions that can influence the cash flows ultimately received by the parent include the financing arrangement (parent versus subsidiary financing of the project), blocked funds by the host government, and host government incentives.

13
Motives for Direct Foreign Investment: �Revenue Related Motives
Motives for Direct Foreign Investment:�Cost Related Motives
Benefits of DFI
Exhibit 13.1 Summary of Motives for Direct Foreign Investment
Exhibit 13.2 Steps Taken by MNCs to Determine Whether to Pursue Direct Foreign Investment
Exhibit 13.4 Risk-Return Analysis of International Projects
Exhibit 13.6 Comparison of Expected Economic Growth among Countries: Annual Stock Market Return
Host Government View of DFI
Host Government View of DFI (Cont.)
Host Government View of DFI (Cont.)
SUMMARY
SUMMARY (Cont.)
14
Subsidiary versus Parent Perspective
Exhibit 14.1 Process of Remitting Subsidiary Earnings to Parent
Subsidiary versus Parent Perspective
Input for Multinational Capital Budgeting
Input for Multinational Capital Budgeting (Cont.)
Input for Multinational Capital Budgeting (Cont.)
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Other Factors to Consider
Adjusting Project Assessment for Risk
SUMMARY
SUMMARY (Cont.)