modes of entry and fdi

8/8/2019 Modes of Entry and FDI

1/27

Competitive Strategies:

Modes of Entry and FDI

Professor Daniel F. Spulber


2/27

2

Enron India

What risks did Enron face going into the

Dabhol project?

Political risk: expropriation of

investment

Political risk: renegotiation of contractsafter investment

Contract risk: problems with local

partners

Currency risk

Market risk: costs of energy anddemand for electric power

Recovery of investment costs (FDI)


3/27

3

Enron India

How did Enron prepare for the risks of the

project?

Long term contracts: purchase

agreement, Maharashtra State Electrical

Board was a credible buyer Political risk: participation of Overseas

Private Investment Corp, US Export-

Import Bank, International Finance

Corp.

Revenues tied to US dollar Partners GE and Bechtel

Substantial research


4/27

4

Enron India

How could Enron have dealt with risk more

effectively?

Enron could have relied less on FDI

Enron could have emphasized

transactions, making arrangements forconstruction, power supply contracts,

and technology transfer

More reliance on local partners to

construct and operate project

Greater participation of other Indianinstitutions


5/27

5

Enron India

Why did Enron choose ownership (FDI)?

To exercise control over assets in

investment projects

To control technology due to limits on

intellectual property rights To improve operational effectiveness

To learn about market for future projects

To avoid expected contract risk


6/27

6

Enron International Operations


7/27

7

Financial Highlights: Growth in assets


8/27

8

FDI is a key aspect of International Business

FDI is what makes the company a multinational firm


9/27


10/27

10

FDI

World FDI inward stock: $8,245 billion (2003)

Sales of foreign affiliates: $17,580 billion (2003)

(Compare with international trade of$9,228 billion (2003)

Gross product of foreign affiliates: $3,706 billion (2003)(Compare with world GDP of$36 trillion in 2003).

Total assets of foreign affiliates: $30,362 billion (2003)

Employment of foreign affiliates: Over54

million people(2003 estimated)

Data from United Nations World Investment Report andUNCTAD website


11/27

11

FDI

2003$

Billions

FDI inflows FDI outflows

Developedcountries

367 570

Developing

countries

172 36

Central and

Eastern

Europe

21 7


12/27

12

International modes of entry and value at risk

FDI whether M&A or company growth puts full value

at risk.

Toyota factory, Wal-Mart store

Managers of an international business choose the mode of

entry based on a trade-off between risk versus control in

the particular supplier or customer country

Joint ventures, not only share knowledge, but also share

investment costs and value at risk

Spot or contract sales can substantially reduce value at risk


13/27

13

International modes of entry and value at risk

M&A

Growth

Alliances/

Joint

Ventures

Licenses

Contract

Spot

Increase in

control

,

Increase in

commitment

and risk

Choice of entry mode jointly determines

degree of control and extent of risk

Degree of commitment depends on

contractual duration and vertical integration

With less knowledge of other countrys

market, choose lower degree of commitment

As knowledge increases over time, can

increase degree of commitment to get closer

to desired entry mode.

Contractual transactions may give optimal

mix of control and commitment


14/27

14

Choosing target countries for FDI

Costs of investment project K

Estimate potential expected returns V(K)

Determine risks associated with revenues and costs in host

country -- Best estimates of expected cash flow

Apply appropriate risk-adjusted discount rate r


15/27


16/27

16

Apply NPV analysis to choose

target country for FDI

Example: Investment cost is K = $2,000

Investment in Country A yields an expected net cash

flow of$12,600 with risk-adjusted discount rate of

20% NPV Country A = $8,500

Investment in Country X yields an expected net cash

flow of$13,000 with risk-adjusted discount rate of30% NPV Country X = $8,000

Invest in Country A


17/27

17

Apply NPV analysis to choose

level of FDI

)1(

)(max

r

KVKtoKChoose

)1(

*)(1

r

solvesInvestment

d!

Therefore, 1 + r = V'(K*)


18/27

18

Companies invest less in riskier countries

all other things equal

*)(1 KVr d!

1 + 0.2

1 + 0.3

KK* K*

$/K

V(K)

Expected marginal return to FDI equals 1 + r.

Note diminishing marginal return to investment


19/27

19

FDI Example: Choosing the level of investment

Let r = 0.2

What level of

investment

should themanager

choose?

V'(K) = 3.2 .5K.

1 + 0.2 =3

.2 .5K*K* = 4.

K V(K) =

3.2K.25K2K+

V(K)/(1 + 0.2)

1 2.95 1.458

2 5.40 2.5

3 7.35 3.125

4 8.80 3.333 ***

5 9.75 3.125

6 10.20 2.5


20/27

20

Why is FDI so common in international business?

Advantages of FDI

Production or distribution facilities in a country can reduce

costs of trade (transportation, tariff and nontariff barriers,

transaction costs, and time) Toyota in US

Production within a country takes advantage of domestic

sourcing of parts, components, services

Investment and employment in host country gain politicalsupport for the international business:

quid pro quo investment Cemex and Southdown


21/27

21

Why is FDI so common in international business?

Advantages of FDI

Closer to customers for manufacturers

Necessary for retail and wholesale companies Wal Mart,

Carrefour, Ingram Micro

Take advantage of low-cost labor, highly-skilled labor, and

proximity to resources

Reduce costs of trade from import/export


22/27

22

Advantages of vertical FDI

Coordination advantages through the value chain

Access to production facilities, sourcing networks and

distribution networks

Keeping technology and intellectual property in-house

Substitution of internal transactions for market transactions


23/27

23

Advantages of Horizontal FDI

M&A acquisition of competitors for market power or costsavings

M&A to achieve economies of scale and scope

(Daimler/Chrysler, VW)

M&A to purchase of technology M&A to acquire brand names

Production avoids costs of trade relative to export

As hedge against demand and supply fluctuations --

Cemex Market power in international purchasing (e.g.

Vodaphone/Airtouch purchases wireless equipment for its

many operations)


24/27

24

Disadvantages of FDI

Risk that firm many not recover investment and returns to

investment in supplier country

FDI increases capital investment, reduces flexibility

FDI ties business to particular country locations for

production or distribution

Vertical FDI makes the firm more vertically integrated


25/27

25

FDI Trends

Shift of investment mix toward servicesAbout half in 1990, about two thirds in 2000

Shift of investment to outsourcing abroad (offshoring +

outsourcing) reduction in vertical integration

Globalization (lower costs of trade) leading to reduction in

vertical FDI

Globalization (market integration) likely to lead to increases in

horizontal FDI

UNCTAD World Investment Report 2004


26/27

26

Licensing versus FDI

Why is FDI more prevalent than technology licensing?

Licensing agreements depend heavily on international

enforcement ofintellectual property rights

International licensing also entails costs of trade

International licensing is quite common amongst

developed countries, reaching levels up to 1/3 of domestic

R&D expenditures

International licensing experiencing rapid growth


27/27

27

Overview and Take-Away Points

FDI a major feature of international business compositionof FDI undergoing transformation from vertical tohorizontal

FDI offers advantages in terms of ownership and control andavoiding trade barriers

Choose target countries based on expected cash flow andcosts of investment and discount using risk adjusted rate of

return

Adjust level of investment to reflect expected cash flow andrisk-adjusted rate of return

modes of entry and fdi

Documents