Transcript Foreign Direct Investment Theory & Strategy

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
Slide 15-1
Copyright © 2003 Pearson Education, Inc.
Chapter 15
Foreign Direct Investment
Theory & 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
Copyright © 2003 Pearson Education, Inc.
Slide 15-2
Chapter 15
Foreign Direct Investment
Theory & 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
Copyright © 2003 Pearson Education, Inc.
Slide 15-3
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-4
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-5
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-6
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-7
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-8
Sustaining & Transferring
Competitive Advantage
 Some of the competitive advantages enjoyed by
MNEs are
• Financial strength
• Differentiated products
• Competitiveness of the their home market
Copyright © 2003 Pearson Education, Inc.
Slide 15-9
Porter’s Diamond of National
Competitive Advantage
Factor Conditions
Firm strategy,
structure, & rivalry
Demand conditions
Related & supporting industries
Copyright © 2003 Pearson Education, Inc.
Slide 15-10
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-11
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-12
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-13
The OLI Paradigm & Internalization
Copyright © 2003 Pearson Education, Inc.
Slide 15-14
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-15
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-16
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-17
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-18
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-19
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-20
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-21
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-22
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-23
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-24
How to Invest Abroad: Modes of FDI
Trident and its
Competitive Advantage
Change
Competitive Advantage
Greater Foreign Presence
Exploit Existing Competitive
Advantage Abroad
Production at Home:
Exporting
Production Abroad
Licensing
Management Contract
Greater
Foreign
Investment
Joint Venture
Greenfield
Investment
Copyright © 2003 Pearson Education, Inc.
Control Assets
Abroad
Wholly-Owned
Subsidiary
Acquisition of a
Foreign Enterprise
Slide 15-25
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-26
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-27
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-28
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-29
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
Copyright © 2003 Pearson Education, Inc.
Slide 15-30