Foreign Direct Investment (FDI) - Necessary Considerations of a Transnational Company

Content

1 What is Foreign Direct Investment

2 TNC and FDI
2.1 Motivation
2.2 Strategies and Sequences
2.3 Evaluation of FDI / Capital Budgeting
2.4 Operational Financial Management after Initial Investment

3 Risks in Connection with FDI

4 Spillover Effects on Host Country

5 Conclusion

References

1 What is Foreign Direct Investment

Geneva, 24 June 2009 -- Global foreign direct investment (FDI) inflows and cross-border mergers and acquisitions (M&As) - the main mode of FDI - drastically declined in the last quarter of 2008, and the fall has continued into 2009, UNCTAD data reveal. FDI inflows dropped by 54% and M&As by 77% during the first quarter of 2009 as compared to the same period last year. Prospects for FDI will remain gloomy for the rest of the year, UNCTAD economists say.¹

Foreign Direct Investment (FDI) is defined by the IMF as an international investment of one company with the intention of lasting relationship. This investment has to exceed 10% of equity of the target company. Also an ambition of the management for influence should be visible. This makes the difference to a portfolio investment.²

The following list summarizes major requirements:

- Transfer of capital
- Control investment
- A source of funds for foreign operations
- A balance of payments flow

Before the financial crisis hit the world economy, FDI was one of the major drivers of globalization and continuously increasing with high growth rates. FDI flows over a long period of time even increased faster than world GDP growth. But as reported from the UNCTAD World Investment Report 2009 85% of Transnational Corporations (TNC)³ worldwide are negatively affected by the financial crisis with respective negative impacts on their investment decisions.⁴ This shortfall has also consequences to the landscape of FDI. The USA are still number one in FDI flows but a lot of emerging countries have risen in the list of top FDI inflows. This is another hint for the changes in the world. The emerging markets will more and more take over a leading position in world economics and also a stabilizing function. They will also head the recovery in FDI flow which is expected to take place in 2010.

This paper will primarily deal with the TNC and their decision for FDI. Starting with the motivations, the following process and evaluation criteria, also associated risks have to be taken into account. For a complete picture including the environment a short look at the host country and the effects of FDI will be done at the end (the decision of the TNC is always connected with respective influences from outside). Finally, all major considerations of a TNC in combination with FDI should be described.

2 TNC and FDI

2.1 Motivation

Building up and expanding a profitable corporation in a country is already a big challenge. But the step to expand beyond national borders is a step accompanied by high complexity and many additional risks. Then why do corporation choose to invest abroad?

There are many reasons for a corporation to take that step. In general a corporation seeks for new or further exploits an existing competitive advantage. Practically this should lead to an increase of revenues or a reduction of costs with the following typical occurrences⁵:

Revenue-related:

- Attract new sources of demand
- Enter profitable Markets
- Exploit monopolistic advantages
- React to trade restrictions
- Diversify internationally

Cost-related:

- Fully benefit from economies of scale
- Use foreign factors of production
- Use foreign raw materials
- Use foreign technology
- React to exchange rate movements

The first step for any corporation is to be aware of the general possibility of creating an advantage with the means of FDI. But FDI is always combined with a heavy risk to fail (please refer to chapter 3 for more details). Therefore a well elaborated strategy for the process of FDI is needed.

2.2 Strategies and Sequences

After having achieved the awareness of a profitable investment abroad, the concrete mode of entry has to be planned. Typically four types are distinguished:⁶

1. Export
2. Licensing
3. Affiliate entry
4. Foreign production

In this list the order also represents the impact of risks and financial burden. Therefore only point three and four represent real FDI as it is defined by the UN.

Export to another country typically does not involve high investments. The corporation willing to export needs to find a company willing to import the goods and further distribute them in the host country. Sometimes the exporter builds up a local office to improve the contacts with the importer/distributor and/or to support the local distribution with sales expertise (e.g. building up an own sales force organization).

Licensing also does not involve heavy investments. This is the case when for example technology is granted for royalties.

Real FDI then comes up when a corporation invests in an affiliate or even establishes a foreign production. The typical approaches to this are

- Greenfield investments
- Mergers & Acquisitions
- Joint Ventures

Greenfield investments take a lot of time and heavy investments are necessary before the needed facilities are set up. But there are also many opportunities. This begins with independency from any partners, or when the corporation has a well- known brand-name which will make the market entry much easier. The new factory of Volkswagen in Russia is an example for a problematic Greenfield investment. It has taken much more time to set up the factory and reach the production rates as originally planned. One main factor was the human capital. It was not as easy to find enough necessary skilled workers, so that many more expatriates had to be sent there, which is also a costly alternative.

Mergers & Acquisitions are a popular possibility to enter a foreign market very quickly. But recent studies have shown that many mergers fail after a short period of time. Very often costs for M&A are higher than estimated and synergies are lower. Reasons are often cultural differences or even the lack of knowledge concerning the other company’s know-how, resources and processes which then do not fit to the own one’s as planned or have been overvalued. One popular example is DaimlerChrysler where the failure became obvious even after years.

Joint Ventures are a possibility often chosen when high investments are necessary, high risk is faced, lack of necessary knowledge exists or within a political regulated environments. Hereby two partners agree on cooperating within a specific part of their business at fixed conditions. There are many cases when countries restrict the access to their home market without cooperation with a local company. For example in the pharmaceutical industry a development of a new drug takes many years and needs high investments. Often two companies share the risk, benefit from each other’s know-how and at the end divide the worldwide distribution rights or agree on royalty payments.

2.3 Evaluation of FDI / Capital Budgeting

Before the aspired investment will be done, it has to be calculated in detail whether this investment reaches a demanded profitability. The most common approach is the calculation of a net present value. For the calculation all future cash flows in connection with the investment have to be estimated and discounted with an interest rate based on the cost of capital. If the calculated present value exceeds the initial investment expenses, the investment should be accepted.⁷

Due to the fact that FDI ia an international procedure the calculation is influenced by more factors than in a domestic investment case. This is a selection of important issues to be considered additionally:⁸

- Parent or project evaluation
- Exchange rates
- Inflation
- Taxes
- Government regulations and subsidies
- Financing
- Etc.

A topic which is discussed very much and handled differently in corporations is the question from which point of view should the calculation been done, from the parent company or using the local viewpoint on the specific project? One may argue that the all worldwide investments of a TNC have to be calculated from the parental point of view with a common cost of capital rate. The local view could say that all projects are different and you have to judge each investment involving the local circumstances.

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¹ UNCTAD, 2009. Press release.

² IMF, 1993. Article 359 on page 86.

³ Transnational Corporation is defined by UNCTAD as an enterprise which comprises entities located in two or more countries, please rewfer to UNCTAD Structure of TNCs

⁴ UNCTAD, 2009. World Investment Report 2009.

⁵ Madura, 2006.

⁶ Moosa, 2002.

⁷ Shapiro, 2009.

⁸ Eitemann, Stonehill, Moffett, 2007.