Part 2 International Corporate Finance - Lecture n° 9 FDI Theory and Strategy

1. International Finance Part 2 International Corporate Finance - Lecture n° 9 FDI Theory and Strategy

2. Why do firms become multinational? • Five categories of strategic motives: • Market seekers • Raw material seekers • Production efficiency seekers • Knowledge seekers • Political safety seekers • In markets where oligopolistic competition: subclassified into proactive and defensive investments

3. Why do firms become multinational? • Markets imperfections : a rationale for the existence of multinational firms • Imperfections in the market for products translate into market opportunities for MNEs. • Sustaining and transferring competitive advantage • First step: Identification • The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad. • It implies for an MNE to have one or several of the following elements, that would give them an edge over their local competitors to exploit these market opportunities.

4. Why do firms become multinational? • Sustaining and transferring competitive advantage • The superiority of a MNE may come from : • Economies of scale and scope • Managerial and marketing expertise • Advanced technology • Financial strength • Differentiated products • Competitiveness of the Home Market • It can increase firm’s competitive advantage in operating abroad. • Referred to as the “diamond of national advantages”.

5. Why do firms become multinational? • “Diamond of national advantages”: • Factor conditions : availability of appropriate factor production • Demand conditions : demanding customers increase marketing and quality control skills. • Related and supporting industries • Firm strategy, structure and rivalry : a competitive home market forces firms to fine tune their strategy and operational effectiveness. • Global competitions in oligopolistic industries may substitute for domestic competition : telecom, high-tech, cosmetics...

6. Why do firms become multinational? • The OLI paradigm and internalisation • Creates a framework to explain the prevalence of FDI over other forms of international expansion. • The conditions for a successful investment require a competitive advantage to be : • O : owner-specific : can be transferred abroad. Ex. Product differentiation. • L : location-specific : will be exploitable in the targeted market. Ex. Market imperfections or competitive advantage. • I : internalisation : the competitive position is preserved by controlling the entire value chain in the industry. Ex. Proprietary information and human capital control in research-intensive industries.

7. Where to Invest ? • In theory, a firm should search the best location world-wide to take advantage of market imperfections and enjoy its competitive advantages. • In practice, firms have been observed to follow a sequential search pattern. This relates to two behavioral theories of FDI : • Behavioral approach : firms tend to invest first in countries that are not too far in psychic terms and for limited investments. Psychic distance is defined in terms of cultural, legal and institutional environment. As firms learn, they are willing to take more risks, both in terms of distance and size of investments. • International network theory : sees MNE as a member of an international network with nodes based in each of the foreign subsidiaries, competing with each other and influencing the strategy and the reinvestment decisions.

8. How to Invest Abroad ? • Modes of Foreign Involvement • Exporting versus Production Abroad • Exporting : none of the risks faced with FDI • Disadvantages of exporting : inability to internalise and exploit the results of R&D investments. • Risk of losing markets to imitators and global competitors. • Licensing and Management Contracts vs. Control of Assets Abroad • Licensing : popular method to take advantage of foreign markets without committing sizeable funds. Political risk is minimized. • Disadvantages of licensing : license fees lower than FDI profits

9. How to Invest Abroad ? • Licensing and Management Contracts • Other disadvantages : • Possible loss of quality control • Establishment of a potential competitor • Risk of technology stolen, or becoming outdated • High agency costs • In practice, MNE’s use licensing with foreign subsidiaries or with joint ventures. • Management contracts are similar to licensing in terms of cash-flows, and reduce political risk since repatriation of managers is easy. • Cost effective of licensing with regard to FDI depends on the price host countries will pay for the services. • Since MNE continue to prefer FDI, the price is assumed to be too low (due to the lack of synergies in licensing?) • MINI - CASE : Benecol’s global licensing agreement.

10. How to Invest Abroad ? • Joint Venture vs. Wholly Owned Subsidiary • Partially owned foreign business : termed as foreign affiliate (case of a joint venture). Foreign business owned at more 50%: foreign subsidiary • Key success factor of a joint venture : find the right local partner. • Some advantages of a local partner : • Better understanding of the local market; • Provision of competent management, and/or appropriate local technology; • Enhanced contacts and reputation, eased access to the local financial markets. • Potential disadvantages : • Risk of conflicts and difficulties, divergent views, decreased control over financing or over production rationalisation; • Increased political and reputation risk, if the wrong partner is chosen.

11. How to Invest Abroad ? • Greenfield investment vs. Acquisition • Greenfield investment : establishing a production or service facility starting from the ground up. • Cross-borders acquisitions : quicker, could be more cost-effective in gaining competitive advantage such as technology, brand names, logistic and distribution. • Disadvantages of cross-borders acquisitions : • Problems of paying a too high price (but some undervaluation cases, too, especially in crisis situation), • Difficulties on the post-acquisition process, and the merger of different corporate cultures. • Additional difficulties from host governments intervention in pricing, financing, employment guarantees…

12. How to Invest Abroad ? • Strategic alliances - different stages : • Simple exchange of share ownership (as a takeover defense); • Establishment of a separate joint venture to develop and manufacture a product or a service (common in high-tech industries); • Joint marketing and servicing agreement (often forbidden by national laws)

13. Multinational Capital Budgeting • Multinational Capital Budgeting • Same theoretical framework • The net present value criteria can be applied based on the expected cash flows of the project, like in case of a domestic investment. • Complexities of budgeting a foreign project • Parent cash flows must be distinguished from project cash flows, each contributing to a different view of value; • Financing mode, remittance of funds, tax systems, differing inflation rates and foreign exchange rate movements must be taken into account; • Political risk and government interference should be included in the analysis • Terminal value is more difficult to estimate, because of various potential purchasers, in host country or abroad, public or private.

14. Multinational Capital Budgeting • Project versus Parent Valuation • Strong theoretical statement to analyse the project from the point of view of the parent, since it is the ultimate basis for dividend payments and other reinvestment decisions. • However, this violates the rule that, in capital budgeting, financial cash flows should not be mixed with operating cash flows. • Evaluation of a project from a local viewpoint serves some useful purposes and should be subordinated to evaluation from the parent’s viewpoint. In practice, firms use both viewpoints for evaluation. • General rules • Almost any project should be at least giving the same return to that on host government bonds, that is generally the local risk-free rate including a premium reflecting the expected inflation rate (Ex. 33% in India). • Multinational firms should invest only if they can earn a risk-adjusted return greater than their locally based competitors.

15. Multinational Capital Budgeting • Illustrative case : Cemex enters Indonesia • See reference textbook pp 354 - 365 • For information and illustration • Project valuation sensitivity analysis • First valuation is made on a set of “most likely” assumptions. • Next, and in particular in uncertain environments, a sensitivity analysis is required, under a variety of “what if” scenarios. • For example, in international projects : • Political risk : what if the host country imposed controls on dividend payment, what if funds are blocked? • Foreign exchange risk : how is the value of the project affected by a x% decrease (increase) in the host currency rate? What about the relative impacts of competitiveness and cash flows changes? • Other sensitivity variables : change in the assumed terminal value, the capacity utilisation rate, the initial project cost...

16. Multinational Capital Budgeting • Real Option Analysis • For investments that have long lives, cash flows returns in later years, or higher levels of risks compared to the current business of the firm, are often rejected by the DCF approach. • When MNE’s evaluate competitive projects, DCF analysis fails to capture the strategic options that an investment may offer. • Real option analysis overcomes this weakness by applying option theory to capital budgeting decisions. It is a cross between decision-tree analysis and pure option-based valuation. • Very useful when analysing investment projects that can take very different values depending on the decisions made at certain points in time (defer, abandon, reduce capacity,..). The range of values give the volatility of the project’s value. • MINI-CASE : Trident’s Chinese Market entry.

17. Adjusting for Risk in Foreign Invt • Defining risk • One-sided risk : only potential for loss. Example : expropriation, blocked funds. Often described in probabilities of occurrence, qualitative in character. Best thought of as “acceptable” / “unacceptable”. • Two-sided risk : risk of loss or gain. Example : foreign exchange, host government economic policies. Often assessed through statistical analysis, allowing rank-order of investments alternatives. • Risk measurement origins • From the market : credit spreads, sovereign spreads. • From institutions : constructed indices ranking countries on the basis of their macro risk fundamentals, i.e. political and economic stability. Inherently subjective.

18. Adjusting for Risk in Foreign Invt • Defining Foreign Investments Risks • Firm-specific risks : micro risks, at project or corporate level • Country-specific risks : macro risks, affecting the project, but originated at the country level • Global-specific risks • see illustration

19. Firm-Specific Risks Country-Specific Risks Global-Specific Risks • Business risks • Transfer risk • Terrorism • War and ethnic strife • Foreign-exchange risks • Anti-globalization movement • Nepotism and corruption • Governance risks • Defective economic and social infrastructure • Cyber attacks • Poverty • Macroeconomic disequilibrium • Environmental safety • Sovereign credit risk • Cultural and religious heritage • Intellectual property rights Foreign Investment Risks

20. Adjusting for Risk in Foreign Invt • Strategies of Foreign Investments Risks Management • Sensitivity Analysis • Minimize Assets at Risk • Diversification • Insurance • see illustration

21. Risk Management Strategies Sensitivity Analysis Minimize Assets at Risk Simulating business plans Minimize equity in subsidiary Adjusting discount rate Borrow locally Adjusting cash flows Diversification Insurance Plant location Hedging currency risk Source of debt & equity Risk-sharing agreement Currency of denomination Country investment agreements Supply sources Investment guarantees Sales locations

22. Adjusting for Risk in Foreign Invt • Measuring and Managing Foreign Investments Risks • Business risk : project viewpoint measurement vs. parent viewpoint measurement (adjusting discount rates or adjusting cash flows), and portfolio risk measurement • Foreign exchange risk : see previous lectures • Governance risk management : • Negotiate investment agreements • Investment insurance and guarantees : specific institutions • Operating strategies after FDI decisions : local sourcing, facility location, control of transportation, control of technology, control of markets, brand name and trademark control, thin equity base, multiple-source borrowing.

23. Adjusting for Risk in Foreign Invt • Country-specific risks • Transfer risk: limitations on the MNE’s ability to transfer funds into and out of the host country without restrictions. Restrictions usually decided by a government running out of foreign currency reserves. Most severe form of restriction is non convertibility. • Three types of reactions for MNE’s : • Prior to investment : analyse the risks and their effects in the project design • During operations : move funds using various techniques • If movements of funds are impossible, find the best reinvestment alternatives in the host country.

24. Adjusting for Risk in Foreign Invt • Country-specific risks • Moving blocked funds : techniques • Use of alternative conduits • Adapt transfer pricing of goods and services between parent and subsidiaries • Use leading and lagging payments • and : • Fronting loans : parent to subsidiary loan channelled through a financial intermediary in a third country (“link financing”) • Create unrelated exports : help easing the currency shortage for the host currency • Obtain special dispensation : possible for some key industries.

25. Transfer Risk Cultural Differences Protectionism • Religion • Defense industry • Blocked funds • Macroeconomic disequilibrium • Nepotism and corruption • Agriculture • Economic infrastructure • Infant industry • Intellectual property rights • Sovereign credit risk Country-Specific Risks Country-Specific Risks: Measurement and Management

26. Adjusting for Risk in Foreign Invt • Global-specific risks • Terrorism • Anti-globalization movement • The role of international institutions such as the IMF and World Bank • Environmental concerns • Poverty • Cyber attacks