International Financial Management PDF

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Foreign Investment Decisions: Structuring & Implementation UNW...

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Foreign Investment Decisions: Structuring & Implementation UNWE, IFM Course References: OECD, IMF, Madura, J., IFM, 9e, Long-Term Asset and Liability Management: FDI © © Tzvetomir T.Tzanov, Tzanov, Ph.D. Ph.D, UNWE  International Financial Management Outline MNC engage in foreign investment: - intra-firm in real assets (PP&E), projects; - but also, in existing or, in the establishment of new companies (direct investments). Thus, necessary description of Foreign direct investment (FDI) – definitions and forms. Common motives for FDI. Illustration of the benefits of international diversification in a portfolio theory context. © T.Tzanov, Ph.D, UNWE  International Financial Management Foreign direct investment OECD Benchmark Definition of FDI: FDI reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘direct investor’) in an entity resident in an economy other than that of the investor (‘direct investment enterprise’). Direct investment enterprise - in which a foreign investor owns 10 per cent or more of the ordinary shares or voting power of an incorporated enterprise or the equivalent of an unincorporated enterprise. © T.Tzanov, Ph.D, UNWE  International Financial Management Foreign direct investment (2) OECD’s Benchmark definition fully consistent with IMF’s Balance of Payments Manual, Fifth Edition. Statistical purposes – Balance of payments. Reported in relevant documents (e.g. by National banks, Eurostat, Nat. Statistics). Direct investment enterprise – incorporated (subsidiary or associate company) or unincorporated (branch). Subsidiaries & Associates: Subsidiary – where the investor (parent) owns > 50% of shareholders’ or members’ voting power, or the right to appoint/remove the majority within company’s management bodies. Associate – where the investor (company incl. its subsidiaries) own between 10 and 50 per cent (methodological issues). © T.Tzanov, Ph.D, UNWE  International Financial Management Forms of FDI Organizational and entry mode perspectives: JV; M&A (incl. privatization); Green-field (Brownfield). Alternative choices following capital & risk sharing considerations. © T.Tzanov, Ph.D, UNWE  International Financial Management Motives for FDI FDI can improve profitability and enhance shareholder wealth (Madura, 2012), either by boosting revenues or reducing costs. Note: Not always shareholder wealth (Shapiro; European & Asian scholars) – state companies, strategic (market seeking) and discretion perspective. Classification of motives (differences & interrelation): Revenue-Related Motives  Attract new sources of demand, especially when the potential for growth in the home country is limited. © T.Tzanov, Ph.D, UNWE  International Financial Management Motives for FDI Revenue-Related Motives  Enter profitable markets.  Exploit monopolistic advantages, especially for firms that possess resources or skills not available to competing firms (theoretical considerations: Hymer, Kindleberger – International Business context).  React to trade restrictions. © T.Tzanov, Ph.D, UNWE  International Financial Management Motives for FDI Cost-Related Motives  Fully benefit from economies of scale, especially for firms that utilize much machinery.  Use cheaper foreign factors of production.  Use foreign raw materials, especially if the MNC plans to sell the finished product back to the consumers in that country. (Product lifecycle theory, Vernon).  Use foreign technology.  React to exchange rate movements, such as when the foreign currency appears to be undervalued. FDI can also help reduce the MNC’s exposure to exchange rate fluctuations.  Diversify sales/production internationally (Internalization theory perspective – Buckley & Casson). © T.Tzanov, Ph.D, UNWE  International Financial Management Motives for FDI The optimal method for a firm to penetrate a foreign market is partially dependent on the characteristics of the market. For example, if the consumers in the host country are used to buying domestic products, then licensing arrangements or joint ventures may be more appropriate. Eclectic theory (OLI Paradigm) – Dunning. Before investing in a foreign country, the potential benefits must be weighed against the costs and risks. As conditions change over time, some countries may become more attractive targets for FDI, while other countries become less attractive – country risk assessment. © T.Tzanov, Ph.D, UNWE  International Financial Management Foreign investment assessment Assessment of a combination of projects: Alternatives for International diversification: Portfolio theory methodology (H. Markowitz). Assessment of individual projects: Multinational capital budgeting techniques. Traditional capital budgeting methodology. © T.Tzanov, Ph.D, UNWE  International Financial Management Benefits of International diversification The key to international diversification is to select foreign projects whose performance levels are not highly correlated over time.  p = wA A + wB B + 2 wA wB A B (CORR AB) 2 2 2 2 2 w – percentage of total funds allocated to investments А and В respectively; σ – standard deviations of returns on investments A and B respectively; CORR – correlation coefficient of returns between investments А and В. © T.Tzanov, Ph.D, UNWE  International Financial Management Diversification benefits – Case analysis Merrimack Co. is a U.S. firm that is considering the location of a new investment project. Characteristics of Proposed Project If located in the U.S. the U.K. Project’s mean expected annual after-tax return 25% 25% Standard deviation of project’s return.09.11 Correlation of project’s return with return on existing.80.02 U.S. business © T.Tzanov, Ph.D, UNWE  International Financial Management Diversification benefits – Case (2) In terms of return, neither new project has an advantage. With regard to risk, the new project is expected to exhibit slightly less variability in returns if located in the U.S. Suppose that the project constitutes 30% of Merrimack’s total funds, and that the standard deviation of Merrimack’s return on existing U.S. business is.10. If the new project is located in the U.S., the portfolio variance for the overall firm will be: σ 2P = wA2 σ 2A + wB2 σ 2B + 2 wA wB σ Aσ BCORRAB =.702.102 +.302.092 + 2(.70)(.30)(.10)(.09 )(.80) =.008653 © T.Tzanov, Ph.D, UNWE  International Financial Management Diversification benefits – Case (3) If the new project is located in the U.K., the portfolio variance for the overall firm will be: σ 2P = wA2 σ 2A + wB2 σ 2B + 2 wA wB σ Aσ BCORRAB =.702.102 +.302.112 + 2(.70)(.30)(.10)(.11)(.02 ) =.0060814 Thus, as a whole, Merrimack will generate more stable returns, as a combination of investment alternatives, if the new project is located in the U.K. © T.Tzanov, Ph.D, UNWE  International Financial Management Benefits of International diversification An MNC may not be insulated from a global crisis, since many countries will be adversely affected. However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the Asian countries might have fared better than if it had focused on one country. Even better would be diversification among the continents. Similar – 2008-2010 crisis. Might be a different pattern nowadays (digital economy). © T.Tzanov, Ph.D, UNWE  International Financial Management Benefits of International diversification As more projects are added to a portfolio, the portfolio variance should decrease on average, up to a certain point. However, the degree of risk reduction is greater for a global portfolio than for a domestic portfolio, due to the lower correlations among the returns of projects implemented in different economies. An MNC with projects positioned around the world is concerned about the risk and return characteristics of its projects. Frontier of efficient portfolios. Of the efficient portfolios, an MNC may choose one that corresponds to its willingness to accept risk. © T.Tzanov, Ph.D, UNWE  International Financial Management Decisions subsequent to FDI Some periodic decisions are necessary. Should further expansion take place? Should the earnings be remitted to the parent, or used by the subsidiary? Withholding taxes – important factor to consider. © T.Tzanov, Ph.D, UNWE  International Financial Management Host Government view of FDI For the governments, the ideal FDI should solve problems such as unemployment and lack of capital & technology, without taking business away from the local firms. The governments may provide incentives to encourage the forms of FDI that they are planning to attract and impose preventive barriers or conditions on the forms of FDI that are not desired. The ability of a host government to attract FDI is dependent on the country’s markets and resources (location advantages – OLI), as well as government regulations and incentives (investment climate). © T.Tzanov, Ph.D, UNWE  International Financial Management Host Government view of FDI Incentives to attract FDI: Common incentives offered by the host government include tax breaks, discounted rent for land and buildings, low- interest loans, subsidized energy, and reduced environmental restrictions. Barriers to FDI: Common barriers imposed by the host government include the power to block a merger/acquisition, foreign majority ownership restrictions, excessive procedure and documentation requirements (red tape), and operational conditions. © T.Tzanov, Ph.D, UNWE  International Financial Management FDI decisions and MNC’s value FDI decisions on type of business and location  n  n  E (CFj, n ) E (ER j, n )  j =1  Value =    t =1  (1 + r ) n    E (CFj,n ) = expected cash flows denominated in currency j to be received by the parent for the number of periods n E (ERj,n ) = expected exchange rate at which currency j can be converted to home currency (parent) for every period n r = weighted average cost of capital of the parent © T.Tzanov, Ph.D, UNWE  International Financial Management Long-term Asset and Liability management Existing host country Tax laws Potential Estimated cash revision in host flows of Exchange multinational country Tax rate laws or other project projections provisions Country risk Multinational analysis capital MNC’s access to budgeting foreign financing decisions MNC’s Cost of capital Required return International Interest rates on multinational on long-term project funds Risk unique to multinational project © T.Tzanov, Ph.D, UNWE  International Financial Management THANK YOU FOR YOUR ATTENTION! © T.Tzanov, Ph.D, UNWE