FOREIGN DIRECT INVESTMENT
SUMMARY
LECTURE 1 : MULTINATIONALS AND FDI
FOREIGN DIRECT INVESTMENT
Foreign investment = the flow of financial capital from countries to another.
Foreign direct investment (FDI) = building or purchasing businesses and their associated infrastructure in foreign
countries where the investor has significant degree of control and influence of the foreign management.
Foreign portfolio investment (FPI) = the purchase of securities of foreign countries such as stocks and bonds on an
exchange without controlling stake.
10 percent ownership rule = flow of capital to a foreign firm in which the investor has (or gains) ownership
of 10 percent or more of the foreign firm is considered a FDI (otherwise FPI).
FDI FLOWS VS FDI STOCKS
FDI flow = the amount of FDI moving in a certain direction during a given time interval.
- FDI inflow = the volume of FDI moving into countries
- FDI outflow = the volume of FDI originating from countries
FDI stocks = the total cumulative value of all FDI flows at a certain moment of time.
- Inward FDI stocks = a snapshot of the total cumulative value of foreign direct investments in economies ( =
cumulative value of FDI inflows at a given point in time).
- Outward FDI stocks = a snapshot of the total cumulative value of foreign direct investment held abroad
through resident firms from given countries ( = cumulative value of FDI outflows at a given point in time).
MULTINATIONAL ENTERPRISE (MNE)
MNE = a firm that owns and controls operations in multiple countries : a firm that undertakes FDI (one parent firm
and one or more foreign affiliates : subsidiaries).
MNEs finance a substantial amount of their activities through borrowing in the host countries instead of from the
parent firm because :
- Exchange rate risks = the risks of loss that firms bear when the transaction is denominated in currencies
other than in which the firm operates. It is a risks that occurs due to a change in the relative values of
currencies. Thus MNEs take on liabilities and assets denominated in foreign currencies to reduce
fluctuations in the value of net assets.
- Risks of expropriation = expropriation is the act of a government claiming private owned properties to be
used for the benefit of the public (railroads and airports). Thus MNEs have the possibilities to default on
foreign liabilities if foreign government expropriates firm assets.
,The reason for MNEs is that firms have valuable assets and capabilities (firm-specific advantages) the firms want to
exploit in foreign markets.
Firm-specific advantages = valuable firm-specific tangible and intangible resources and capabilities generate a firm-
specific advantage if the resources are VRIN :
- Valuable
- Rare
- Inimitable
- Non-substitutable
Firm-specific advantages allow the firm to overcome the inherent disadvantages of being foreign ( liabilities of
foreignness) : cultural barriers or travel and communication costs.
SORTS OF FDI
There are 2 sorts of multinational activities :
1. Horizontal (market-seeking) = serving foreign markets direct (producing and selling to consumers abroad) :
replication of home activities in host countries.
2. Vertical (efficiencies-seeking) = sourcing from abroad : locating activities from a different stage of the value
chain to host countries.
FDI VS ALTERNATIVE STRATEGIES
Alternatives to leverage firm-specific assets :
Exporting
Licensing
FDI VS EXPORT
Advantages of FDI over exporting :
- Utilize local resources (cheap labor)
- Circumvent trade barriers and transportation costs
- Get access to trade blocs
- Proximities to foreign customers (distance)
Disadvantages of FDI over exporting :
- Production takes place in multiple locations
- Loss of size advantages (economies of scale)
FDI VS LICENSING
Advantages of FDI over licensing :
- Avoid transaction costs related to licensing
- Control over how firm assets are used
, - Reduce dissemination risks (unintended transfer of knowledge)
Disadvantages of FDI over licensing :
- Local firms are more familiar with the foreign business partner environment
- High costs of establishing and managing foreign operations
OLI MODEL
Dunning OLI model = a three tiered evaluation framework that
firms can follow to determine whether it is beneficial to pursue
FDI.
Ownership advantages = firm-level (intangible) sources
of competitive advantage that help to overcome the
liabilities of foreignness (branding or trademarks to
create reputation).
Location advantages = attractive (immobile) countries-
specific resources that are location-bound often
requiring a partnership with a foreign investor in that
location to be utilized to advantage.
Internalization advantages = the benefits of organizing
cross-border activities in-house instead of in the market
(outsource).
Incomplete contracting = where contracts fail
internal markets arise
Asset specifities = market parties cannot use a firm
technologies or the firm does not want them to
Internal market for transferring tacit knowledge.
In addition to the OLI advantages FDI allows to :
Enhance a firm market power
o Establish competitive thread to foreign rivals
o Setting up a foreign affiliate before the competitor does (first-mover advantages)
Benefit from differential tax regulations in home and foreign countries through making use of transfer
pricing = set prices for firm-internal transactions such that profits are shifted from high-tax to low-tax
countries.
TRANSFER PRICING EXERCISE EXAMPLE
A business consulting firm has affiliates in both Australia where the corporate income tax rate is 25 percent and in
Ireland where the corporate income tax rate is 15 percent. Suppose the juniors work for the Irish affiliate while the
senior consultants are based in Australia. One hour of work though an Irish junior costs EUR 60. The Australian
affiliate charges its clients EUR 700 per hour of consulting services out of which EUR 380 is paid as salaries to the
senior consultants. Suppose that each hour of consulting services charged to the clients requires one hour of work
through an Irish junior. The controller of the firm is considering three possible values for the price at which the
services provided through the Irish affiliate are sold to the Australian affiliate:
, (i) EUR 60 per hour. (ii) EUR 150 per hour. (iii) EUR 240 per hour.
Answer this question through calculating the global after-tax profit of the firm under the three scenarios.
Corporate tax rate Ireland : 15% (0.85)
Corporate tax rate Australia : 25% (0.75)
Costs Irish junior EUR 60
Profits Australian senior EUR 320 (700 – 380)
The transfer price is the price the Australian seniors have to spend for the Irish juniors work thus for the Australian
seniors these are costs and for the Irish juniors these are profits. The idea is to subtract the costs from the profits
and multiplies with the corporate tax rate to calculate the profits for both countries :
Transfer price Profit Ireland Profit Australia Total Profit
60 (60 – 60) x 0.85 = 0 (320 – 60) x 0.75 = 195 195
150 (150 – 60) x 0.85 = 76.5 (320 – 150) x 0.75 = 127.5 204
240 (240 – 60) x 0.85 = 153 (320 – 240) x 0.75 = 60 213
The global after tax profit of the firm is the highest at a transfer price of EUR 240.
COSTS AND BENEFITS OF FDI
FDI effects on home countries :
+
- Profit repatriation (the return of profit to the home countries).
- Learning form operations abroad
- Higher returns to capital
-
- Lower returns to labor
- Domestic labor replaced with foreign labor
- Loss of external benefits associated with domestic production
FDI effects on host countries
+
- Job creation
- Increase in government tax revenue
- Positive externalities (MNEs bring knowledge)
-
- Capital outflow through repatriated earnings (profits from FDI return to the home countries).
- Local firms competing with MNEs lose
SUMMARY
LECTURE 1 : MULTINATIONALS AND FDI
FOREIGN DIRECT INVESTMENT
Foreign investment = the flow of financial capital from countries to another.
Foreign direct investment (FDI) = building or purchasing businesses and their associated infrastructure in foreign
countries where the investor has significant degree of control and influence of the foreign management.
Foreign portfolio investment (FPI) = the purchase of securities of foreign countries such as stocks and bonds on an
exchange without controlling stake.
10 percent ownership rule = flow of capital to a foreign firm in which the investor has (or gains) ownership
of 10 percent or more of the foreign firm is considered a FDI (otherwise FPI).
FDI FLOWS VS FDI STOCKS
FDI flow = the amount of FDI moving in a certain direction during a given time interval.
- FDI inflow = the volume of FDI moving into countries
- FDI outflow = the volume of FDI originating from countries
FDI stocks = the total cumulative value of all FDI flows at a certain moment of time.
- Inward FDI stocks = a snapshot of the total cumulative value of foreign direct investments in economies ( =
cumulative value of FDI inflows at a given point in time).
- Outward FDI stocks = a snapshot of the total cumulative value of foreign direct investment held abroad
through resident firms from given countries ( = cumulative value of FDI outflows at a given point in time).
MULTINATIONAL ENTERPRISE (MNE)
MNE = a firm that owns and controls operations in multiple countries : a firm that undertakes FDI (one parent firm
and one or more foreign affiliates : subsidiaries).
MNEs finance a substantial amount of their activities through borrowing in the host countries instead of from the
parent firm because :
- Exchange rate risks = the risks of loss that firms bear when the transaction is denominated in currencies
other than in which the firm operates. It is a risks that occurs due to a change in the relative values of
currencies. Thus MNEs take on liabilities and assets denominated in foreign currencies to reduce
fluctuations in the value of net assets.
- Risks of expropriation = expropriation is the act of a government claiming private owned properties to be
used for the benefit of the public (railroads and airports). Thus MNEs have the possibilities to default on
foreign liabilities if foreign government expropriates firm assets.
,The reason for MNEs is that firms have valuable assets and capabilities (firm-specific advantages) the firms want to
exploit in foreign markets.
Firm-specific advantages = valuable firm-specific tangible and intangible resources and capabilities generate a firm-
specific advantage if the resources are VRIN :
- Valuable
- Rare
- Inimitable
- Non-substitutable
Firm-specific advantages allow the firm to overcome the inherent disadvantages of being foreign ( liabilities of
foreignness) : cultural barriers or travel and communication costs.
SORTS OF FDI
There are 2 sorts of multinational activities :
1. Horizontal (market-seeking) = serving foreign markets direct (producing and selling to consumers abroad) :
replication of home activities in host countries.
2. Vertical (efficiencies-seeking) = sourcing from abroad : locating activities from a different stage of the value
chain to host countries.
FDI VS ALTERNATIVE STRATEGIES
Alternatives to leverage firm-specific assets :
Exporting
Licensing
FDI VS EXPORT
Advantages of FDI over exporting :
- Utilize local resources (cheap labor)
- Circumvent trade barriers and transportation costs
- Get access to trade blocs
- Proximities to foreign customers (distance)
Disadvantages of FDI over exporting :
- Production takes place in multiple locations
- Loss of size advantages (economies of scale)
FDI VS LICENSING
Advantages of FDI over licensing :
- Avoid transaction costs related to licensing
- Control over how firm assets are used
, - Reduce dissemination risks (unintended transfer of knowledge)
Disadvantages of FDI over licensing :
- Local firms are more familiar with the foreign business partner environment
- High costs of establishing and managing foreign operations
OLI MODEL
Dunning OLI model = a three tiered evaluation framework that
firms can follow to determine whether it is beneficial to pursue
FDI.
Ownership advantages = firm-level (intangible) sources
of competitive advantage that help to overcome the
liabilities of foreignness (branding or trademarks to
create reputation).
Location advantages = attractive (immobile) countries-
specific resources that are location-bound often
requiring a partnership with a foreign investor in that
location to be utilized to advantage.
Internalization advantages = the benefits of organizing
cross-border activities in-house instead of in the market
(outsource).
Incomplete contracting = where contracts fail
internal markets arise
Asset specifities = market parties cannot use a firm
technologies or the firm does not want them to
Internal market for transferring tacit knowledge.
In addition to the OLI advantages FDI allows to :
Enhance a firm market power
o Establish competitive thread to foreign rivals
o Setting up a foreign affiliate before the competitor does (first-mover advantages)
Benefit from differential tax regulations in home and foreign countries through making use of transfer
pricing = set prices for firm-internal transactions such that profits are shifted from high-tax to low-tax
countries.
TRANSFER PRICING EXERCISE EXAMPLE
A business consulting firm has affiliates in both Australia where the corporate income tax rate is 25 percent and in
Ireland where the corporate income tax rate is 15 percent. Suppose the juniors work for the Irish affiliate while the
senior consultants are based in Australia. One hour of work though an Irish junior costs EUR 60. The Australian
affiliate charges its clients EUR 700 per hour of consulting services out of which EUR 380 is paid as salaries to the
senior consultants. Suppose that each hour of consulting services charged to the clients requires one hour of work
through an Irish junior. The controller of the firm is considering three possible values for the price at which the
services provided through the Irish affiliate are sold to the Australian affiliate:
, (i) EUR 60 per hour. (ii) EUR 150 per hour. (iii) EUR 240 per hour.
Answer this question through calculating the global after-tax profit of the firm under the three scenarios.
Corporate tax rate Ireland : 15% (0.85)
Corporate tax rate Australia : 25% (0.75)
Costs Irish junior EUR 60
Profits Australian senior EUR 320 (700 – 380)
The transfer price is the price the Australian seniors have to spend for the Irish juniors work thus for the Australian
seniors these are costs and for the Irish juniors these are profits. The idea is to subtract the costs from the profits
and multiplies with the corporate tax rate to calculate the profits for both countries :
Transfer price Profit Ireland Profit Australia Total Profit
60 (60 – 60) x 0.85 = 0 (320 – 60) x 0.75 = 195 195
150 (150 – 60) x 0.85 = 76.5 (320 – 150) x 0.75 = 127.5 204
240 (240 – 60) x 0.85 = 153 (320 – 240) x 0.75 = 60 213
The global after tax profit of the firm is the highest at a transfer price of EUR 240.
COSTS AND BENEFITS OF FDI
FDI effects on home countries :
+
- Profit repatriation (the return of profit to the home countries).
- Learning form operations abroad
- Higher returns to capital
-
- Lower returns to labor
- Domestic labor replaced with foreign labor
- Loss of external benefits associated with domestic production
FDI effects on host countries
+
- Job creation
- Increase in government tax revenue
- Positive externalities (MNEs bring knowledge)
-
- Capital outflow through repatriated earnings (profits from FDI return to the home countries).
- Local firms competing with MNEs lose
