Prepared by Shafiq Jadallah

1. Chapter 15 Foreign Direct Investment Theory & Strategy Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

2. Chapter 15Foreign Direct InvestmentTheory & Strategy • Learning Objectives • Show why the theory of comparative advantage is the theoretical justification for international trade • Analyze how market imperfections create a rationale for the existence of MNEs • Explain why firms become multinational • Demonstrate how key competitive advantages support MNEs’ strategy to originate and sustain foreign direct investment • Show how the OLI paradigm provides a theoretical foundation for the globalization process

3. Chapter 15Foreign Direct InvestmentTheory & Strategy • Learning Objectives • Identify factors and forces that must be considered in the determination of where MNEs’ invest • Illustrate the managerial and competitive dimensions of the alternative methods for foreign investment

4. The Theory of Competitive Advantage • The theory of competitive advantage provides a basis for explaining and justifying international trade in a model assumed to enjoy free trade, perfect competition, no uncertainty, costless information and no government interference • The features of the theory are as follows • Country A exports goods to unrelated importer in Country B • Country A specializes in certain products given their natural resources • Country B does the same with different products

5. The Theory of Competitive Advantage • Because the factors of production cannot be transported, the benefits of specialization are realized through international trade • The terms of trade, the ratio at which quantities of goods are exchanged, shows the benefits of excess production • Of course, this is only a theory in today’s world. No one country specializes in only one product and the assumptions of the model do not exist in reality

6. Market Imperfections:A Rationale for the MNE • MNEs strive to take advantage of imperfections in national markets • These imperfections for products translate into market opportunities such as economies of scale, managerial or technological expertise, financial strength and product differentiation

7. Market Imperfections:A Rationale for the MNE • Firms become multinational for one or several of the following reasons • Market seekers – produce in foreign markets either to satisfy local demand or export to markets other than their own • Raw material seekers – search for cheaper or more raw materials outside their own market • Production efficiency seekers – produce in countries where one or more of the factors of production are cheaper • Knowledge seekers – gain access to new technologies or managerial expertise • Political safety seekers – establish operations in countries considered unlikely to expropriate or interfere with private enterprise

8. Sustaining & Transferring Competitive Advantage • In order to sustain a competitive advantage it must be • Firm-specific • Transferable • Powerful enough to compensate the firm for the extra difficulties of operating abroad • Some of the competitive advantages enjoyed by MNEs are • Economies of scale and scope • Managerial and marketing expertise • Advanced technology

9. Sustaining & Transferring Competitive Advantage • Some of the competitive advantages enjoyed by MNEs are • Financial strength • Differentiated products • Competitiveness of the their home market

10. Porter’s Diamond of National Competitive Advantage Factor Conditions Firm strategy, structure, & rivalry Demand conditions Related & supporting industries

11. The OLI Paradigm & Internationalization • The OLI Paradigm (Buckley & Casson, 1976; Dunning 1977) is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative modes such as licensing, joint ventures, strategic alliances, management contracts and exporting • The paradigm states that a firm must first have some competitive advantage in its home market - “O” or owner-specific – which can be transferred abroad

12. The OLI Paradigm & Internalization • The firm must also be attracted by specific characteristics of the foreign market – “L” or location specific – which will allow the firm to exploit its competitive advantages in that market • Third,the firm will maintain its competitive position by attempting to control the entire value-chain in its industry – “I” or internalization • This leads to FDI rather than licensing or outsourcing

13. The OLI Paradigm & Internalization • Financial strategies are directly related to the OLI Paradigm in explaining FDI • Strategies can be proactive , controlled in advance by the management team • Strategies can also be reactive, depend on discovering market imperfections

14. The OLI Paradigm & Internalization

15. Where to Invest • Two related behavioral theories behind FDI that are most popular are • Behavioral approach to FDI • International network theory • Behavioral Approach – Observation that firms tended to invest first in countries that were not too far from their country in psychic terms • This included cultural, legal, and institutional environments similar to their own

16. Where to Invest • International network theory – As MNEs grow they eventually become a network, or nodes that operate either in a centralized hierarchy or a decentralized one • Each subsidiary competes for funds from the parent • It is also a member of an international network based on its industry • The firm becomes a transnational firm, one that is owned by a coalition of investors located in different countries

17. How to Invest Abroad: Modes of FDI • Exporting vs. production abroad • Advantages of exporting are • None of the unique risks facing FDI, joint ventures, strategic alliances and licensing • Political risks are minimal • Agency costs and evaluating foreign units are avoided • Disadvantages are • Firm is not able to internalize and exploit its advantages • Risks losing market to imitators and global competitors

18. How to Invest Abroad: Modes of FDI • Licensing/management contracts versus control of assets abroad • Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizable funds • Disadvantages of licensing are • License fees are likely lower than FDI profits although ROI may be higher • Possible loss of quality control • Establishment of potential competitor • Possible improvement of technology by local license which then enters firm’s original home market

19. How to Invest Abroad: Modes of FDI • Possible loss of opportunity to enter licensee’s market with FDI later • Risk that technology will be stolen • High agency costs • Management contracts are similar to licensing insofar as they provide for some cash flow from foreign source without significant investment or exposure • These contracts lessen political risk because the repatriation of managers is easy

20. How to Invest Abroad: Modes of FDI • Joint ventures versus wholly owned subsidiary • A joint venture is a shared ownership in a foreign business • This is a viable strategy if the MNE finds the right local partner • Some advantages include • The local partner understands the market • The local partner can provide competent management at all levels • Some host countries require that foreign firms share ownership with local partner

21. How to Invest Abroad: Modes of FDI • Joint ventures versus wholly owned subsidiary • Advantages of joint ventures • The local partner’s contacts & reputation enhance access to host country’s capital markets • The local partner may possess technology that is appropriate for the local environment • The public image of a firm that is partially locally owned may improve its position

22. How to Invest Abroad: Modes of FDI • Joint ventures versus wholly owned subsidiary • disadvantages of joint ventures • Political risk is increased if wrong partner is chosen • Local and foreign partners have divergent views on strategy and financing issues • Transfer pricing creates potential for conflict of interest • Financial disclosure between local partner and firm • Ability of a firm to rationalize production on a worldwide basis if that would put local partner at disadvantage • Valuation of equity shares is difficult

23. How to Invest Abroad: Modes of FDI • Greenfield investment versus acquisition • A greenfield investment is establishing a facility “starting from the ground up” • Usually require extended periods of physical construction and organizational development • Here, a cross-border acquisition may be better because the physical assets already exist, shorter time frame and financing exposure • However, problems with integration, paying too much for acquisition, post-merger management, and realization of synergies all exist

24. How to Invest Abroad: Modes of FDI • Strategic alliances can take several different forms • First is an exchange of ownership between two firms • It can be a defensive strategy against a takeover • In addition to exchanging shares, a separate joint venture can be developed • Another level of cooperation may be a joint marketing or servicing agreement

25. Greater Foreign Presence Greater Foreign Investment How to Invest Abroad: Modes of FDI Trident and its Competitive Advantage Change Competitive Advantage Exploit Existing Competitive Advantage Abroad Production at Home: Exporting Production Abroad Licensing Management Contract Control Assets Abroad Joint Venture Wholly-Owned Subsidiary Greenfield Investment Acquisition of a Foreign Enterprise

26. Summary of Learning Objectives • The theory of competitive advantage is based on one country possessing a relative advantage in the production of goods compared to another country • Imperfections in national markets for products, factors of production and financial assets translate into market opportunities for MNEs • Strategic motives drive the decision to invest abroad and become an MNE. Firms could be seeking new markets, raw materials, production efficiencies, access to technology or political safety

27. Summary of Learning Objectives • In order to invest abroad a firm must have a sustainable competitive advantage in the home market. This must be strong enough and transferable to overcome the disadvantages of operating abroad • Competitive advantages stem from economies of scale and scope, managerial and marketing expertise, differentiated products, and competitiveness of the home market • The OLI Paradigm is attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through other methods

28. Summary of Learning Objectives • Finance-specific strategies are directly related to the OLI Paradigm, including both proactive and reactive strategies • The decision about where to invest is influenced by economic and behavioral factors • Psychic distance plays a role in determining the sequence of FDI • Most international firms can be viewed from a network perspective. The parent firm and each of the subsidiaries are members of the network

29. Summary of Learning Objectives • Exporting avoids political risk but not foreign exchange risk. It requires the least up-front investment but it might eventually have lost those markets to competition • Alternative modes of FDI exist, such as joint ventures, strategic alliances, licensing, management contracts, and traditional exporting • Licensing enables a firm to profit from foreign markets without a major up-front investment,however disadvantages include limited returns, possible loss of quality control, and potential to establish future competitor

30. Summary of Learning Objectives • The success of a joint venture depends primarily on the right partner. For this reason a number of issues related to possible conflicts in decision making exist • The completion of the European Internal Market induced a surge of strategic alliances