FIN EXAM 5 CHS 17-18

OLI paradigm

• States that a firm must first have some competitive advantage in its home market- “O” for ownership advantages- that can be transferred abroad if the firm is to successful in foreign direct investment

• The firm must be attracted by specific characteristics of the foreign market- “L” for location advantages- that will allow it to exploit its competitive advantages in that market

• The firm will maintain its competitive position by attempting to control the entire value chain in its industry- “I” for internationalization advantages

• Helps to explain the decision by a multinational firm to undertake Foreign Direct Investment

Ownership advantages

A firm must have competitive advantages in its home market and these advantages must be firm specific, not easily copied, and in a form that allows them to be transferred to foreign subsidiaries (product cycle theory)

Location advantages

These factors are typically market imperfections or genuine comparative advantages that attract FDI to particular locations (imperfect market theory)

Internationalization advantages

The key ingredient for maintaining a firm specific competitive advantage is possession of proprietary information and control of the human capital that can generate new information through expertise in research

Financial strategy

Directly related to the OLI paradigm in explaining FDI

Behavioral approach to FDI

• successfully explained not just the initial decision to invest abroad but also later decisions to reinvest elsewhere and to change the structure of a firm’s international involvement over time

• Economists observed that these firms tended to invest first in countries having close psychic distance (similar culture, legal and institutional government)

MNEs in a network perspective

• perceived as being a member of an international network, with nodes based in each of the foreign subsidiaries, as well as the parent firm itself

• Foreign subsidiaries compete with each other and with the parent for expanded resource commitments, thus influencing the strategy and reinvestment decisions

Has none of the unique risks facing FDI, joint ventures, strategic alliances, and licensing with minimal political risks

Advantages of exports

Risk of losing markets to limitations and global competitors, foreign exchange risk

Disadvantages of exports

Licensing

• popular method for domestic firms to profit from foreign markets without a large commitment of funds

• Parent firms do this to subsidiaries or joint ventures to use parent technology or expertise

• fees are lower than FDI profits

• Possible loss of quality control

• Establishing possible competitors

• Risk that technology will be stolen

Disadvantages of licensing

Management contracts

• used by consulting or engineering firms to provide services to foreign customers

• Involve very little foreign investment or exposure risk

Joint venture

Business entity with shared ownership, sharing both risks and returns in the business

Foreign affiliate

Foreign business unit that is partially owned by the parent company

Foreign subsidiary

Foreign business unit that is 50% or more owned by the parent company

• requirement for entry into the host country

• Joining with a partner that brings unique and values qualities or capabilities to the business

• As a way to mitigate the political, business, and capital risks associated with the investment

Motivations for using a joint venture

• local and foreign partners may have divergent views about the need for cash dividends, or about the desirability of growth financed from retained earnings versus new financing

• Transfer pricing on products or components, bought from or sold to related companies, creates a potential conflict of interest

• Ability of a firm to rationalize production on a worldwide basis can be jeopardized if such rationalization would act to the disadvantage of local joint ventures partners

• Financial disclosure of local results might be necessary with locally traded shares or a local partner, whereas if the firm is wholly owned from abroad such disclosure is not needed

• Valuation of equity shares is difficult

• Highly unlikely that a foreign and host country partners have similar opportunity costs of capital, expectations about the required rate of return, or similar perceptions of appropriate premiums for business, foreign exchange, and political risks

• Insofar as the venture is a component of the portfolio of each investor, its contribution to portfolio return and variance may be quite different for each

Potential conflicts with a joint venture

Greenfield investment

A project built from the ground up anew

Acquisition

The purchase of an existing business in country

Strategic alliances

• may take a variety of different forms depending on its primary objective

• Common forms include joint marketing and servicing agreements, cross ownership swaps, and more comprehensive partnerships and joint ventures

Political risk

Possibility that political events in a particular country will influence the economic well being of a firm operating in that country

Firm specific risk

• aka micro risks

• Affect the multinational at the project or corporate level

• Includes government risks (breach of contract, regulatory changes, creeping expropriation) and instability risks (sabotage, boycotts)

Country specific risks

• aka micro risks Affect the

• Affect the MNE at the project or corporate level but originate at the country level

• Includes government risks (expropriation, regulatory changes, blocked funds) and instability risks (strikes, civil unrest, war)

Global risks

Risks that can impact both domestic and multinational enterprises at the project or corporate level it originate at the global level

Expropriation

The taking of private assets for public purposes by the state is still relatively infrequent

Creeping expropriation

Where a government imposes a variety of the various forms of commercial interference, eventually culminating in an effective expropriation

Category 1: losses in operating profitability

• adverse regulatory changes

• Aka regulatory risk

• Refers to changes in hot country regulations that after operating conditions of investments

Breach of contract

Refers to losses arising from a government or state-owned enterprise breaking or breaching of a business contract with the foreign private investor

Local content requirements

Host governments may require foreign firms to purchase raw material and components locally as a way to maximize value added benefits and to increase local employment

Category 2: transfer and convertibility of risk

• aka T&C risk

• The risk that a host country will restrict the ability of the multinational firm to move money in or out of the country- transfer risk- and possibly restrict its ability to exchange local currency for foreign currency- convertibility risk- in an expeditious manner

• This restriction of access and exchange is referred to as blocked funds

• Many countries have been known to restrict convertibility in an effort to stop capital flight and the depletion of foreign exchange reserves

Category 3: expropriation and nationalization

• the most extreme form of political risk is expropriation, the seizure of the multinational company’s business, assets, or license to operate in the country by the government- the public taking of private assets

• The state, any state, has the sovereign right under international law to take property held by private entities, domestic or foreign, through expropriation for economic, political, or social reasons (eminent domain)

Direct expropriation

Transfer of title or outright seizure of property

Indirect expropriation

Using a variety commercial interference measures that incrementally and cumulatively begin to permanently destroy the economic value of the investment

Compensation

• a “lawful expropriation” must be accompanied by this

• Most international investment agreements require this meets three conditions

  • Prompt- paid without delay

  • Adequate- a value with a reasonable relationship with a market value of the investment

  • Effective- paid in a convertible or freely useable currency

Stakeholder engagement

The most frequently cited risk mitigation strategy by multinationals is developing and nurturing relationships with key host country stakeholders

Use of domestic partners

• all host country governments would prefer that new capital projects and business developments in country be undertaken by domestic companies

• Many governments have in the past required a domestic equity partner, requiring in effect a joint venture with a domestic company, as an explicit requirement for entry

International investment agreements

• spells out specific rights and responsibilities of both the foreign firm and the host government

• Pre negotiation of all conceivable areas of conflict provides a better basis for a successful future for both parties than does overlooking the possibility that divergent objectives will evolve over time

• A carefully negotiated IIA prior to entry has been shown to consistently increase the probability of a longer and healthier business venture

Gradual investing

• a multinational firm entering a problematic country may choose to follow a “prudent investment” policy

• This approach is often not well received by host countries

Blocked funds management

• multinational firms can react to the potential for blocked funds at three stages:

  • Prior to investing- a firm can analyze the effect of blocked funds on expected return on investment, the desired local financial structure, and optimal links with subsidiaries

  • During operations- a firm can attempt to move funds through a variety of repositioning techniques; fronting loans, creation of unrelated exports

  • Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or local currency depreciation

Dispute resolution

A common mitigation strategy is therefore to require all disputes to go to international arbitration

Political risk insurance

• providers

• Most political risk insurance is provided by members of the Berne Union, the International Union of Credit and Investment Insurers

Multinational use

MNEs can also sometimes transfer political risk to a host country public agency through an investment insurance and guarantee program

• identify the initial capital invested or put at risk

• Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment

• Identify the appropriate discount rate to use in valuation

• Apply traditional capital budgeting decision criteria such as NPV and IRR

Basic steps of al budgeting for a foreign project

• parent cash flows must be distinguished from project cash flows

• Parent cash flows often depend on the form of financing

• Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary, with the net result that the project is favorable from a single subsidiaries point of view but contributes nothing to worldwide cash flows

• The parent must explicitly recognize remittance of funds because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function

• An array of non financial payments can generate cash flows from subsidiaries to the parent, including payment of license fees and payments for imports from the parent

Capital budgeting for a foreign project is considerably more complex than the domestic case:

• managers must anticipate differing rates of national inflation

• Managers must keep the possibility of unanticipated foreign exchange rate changes in mind

• Use of segmented national capital markets may create an opportunity for financial gains or may lead to additional financial costs

• Use of host government subsidized loans complicates both capital structure and the parent’s ability to determine an appropriate weighted average cost of capital for discounting purposes

• Terminal value is more difficult to estimate

Management expectations:

Parent valuation

• strong argument exists in favor of analyzing any foreign project from the viewpoint of this

• Cash flows to this are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate wide debt, and other purposes that affect the firm’s many interests groups

• However, this viewpoint violates a cardinal concept of capital budgeting, that financial cash flows should not be mixed with operating cash flows

Project valuation

• evaluation of a project from the local viewpoint serves some useful purposes, but it should be subordinated to evaluation from the parent’s viewpoint

• In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we pay attention to the project’s local return

• Almost any project should at least be able to earn a a cash return equal to the yield available on host government bonds

Project vs parent valuation

• multinational firms should invest only if they earn a risk adjusted return greater than locally based competitors can earn on the same project

• If they are unable to earn superior returns on foreign projects, their stockholders would be better off buying shares in local firms, where possible, and letting those companies carry out the local projects

• Most firms appear to evaluate foreign projects from both parent and project viewpoints to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm

Real option analysis

Application of the option theory to capital budgeting decisions; allows one to analyze a number of managerial decisions that in practice characterize many major capital investment projects:

• the option to defer

• The option to abandon

• The option to alter capacity

• The option to start up or shut down

Project financing

The arrangement of financing for long term capital projects, large in scale, long in life, and generally high in risk; basic properties of project finance that are critical to its success:

• separability of the project from its investors

• Long lived and capital intensive singular projects

• Cash flow predictability from third party commitments

• Finite projects with finite lives

Technological change, regulatory change, and capital market change

What creates new business opportunities for MNE’s?

Gain a presence and facilitate competitive entry into the market

By acquiring an existing firm, the MNE shortens time required to what?

Acquisition

___________ may be a cost effective way of gaining competitive advantages, such as technology, brand names valued in the target market, and logistical and distribution advantages, while simultaneously eliminating a local competitor

Cross-border acquisitions, international economic, political, and foreign exchange conditions

These may lead to market imperfections, allowing target firms to be undervalued

• problems of paying too much or suffering excessive financing costs

• Melding corporate cultures can be traumatic

• Managing the post acquisition process is frequently characterized by downsizing to gain economies of scale and scope in overhead functions

• Additional difficulties arise from host governments intervening in pricing, financing, employment guarantees, market segmentation, and general nationalism and favoritism

Disadvantages of cross border acquisitions

Cross border acquisition process stage 1: identification and valuation

Identification of potential acquisition targets requires a well defined corporate strategy and focus

Cross border acquisition process stage 2: completion of the ownership change

The process of gaining approval from management and ownership of the target, getting approvals from government regulatory bodies, and finally determining method of compensation can be time consuming and complex

Cross border acquisition process stage 3: post acquisition transition management

Probably the most critical of the three stages in determining an acquisitions success or failure

Currency risks in cross border acquisitions

• The pursuit and execution of a cross border acquisition poses a number of challenging foreign currency risks and exposures for an MNE

• The assorted risks, both in the timing and information related to the various stages of a cross border acquisition, make the management of the currency exposures difficult